How to protect your portfolio from inflation

How does an investor safeguard her portfolio and goals from high inflation?$S&P500 ETF(SPY)$ $NASDAQ-100 Index ETF(QQQ)$$Apple(AAPL)$$Tesla Motors(TSLA)$

Essentially, there are two broad ways.

Outpacing inflation is about positioning your portfolio to grow bigger over a while and deliver returns that exceed the inflation rate. If your goal is to build a corpus for future spending and the goal is at least ten years away, then this strategy works.

Hedge against inflation broadly focuses on protecting your near-term consumption from rising inflation. It is applicable especially if you are nearing retirement or have short-term goals, thereby giving little leeway to realign your portfolio or improve earnings.

First, lets look at ways to outpace inflation

Adopt Equities

During inflation, input prices usually go up for businesses. If a company has pricing power, it passes on the higher cost to its customers and improves its topline. Even better, if they innovate to fight costs and become productive, their profits improve.

Also, some businesses in the commodities, fast-moving consumer goods and energy space tend to do well during periods of high inflation. Their stocks are therefore the best hedge against inflation. A diversified equity portfolio manager usually shuffles stock holdings periodically to capitalise on these opportunities.

Does high inflation lead to low returns?

Persistently high inflation impacts stock markets negatively, with a lag. 

So, while businesses benefit in the short run from the price increase, in the long run persistently high inflation also impacts consumer demand and pulls down business revenues.

What is encouraging, though, is that equities across the world have historically outperformed inflation over the long term. It translates into a 6-9 percent real return on investments for equity investors.

Uncash, scout for better investment growth options

Don’t keep too much cash on the sidelines, especially during times of inflation. After building an emergency fund, scout for better investment growth opportunities as otherwise, you are essentially losing your purchasing power.

How to hedge against inflation?

Unlike in the US, inflation-indexed bonds that are inherently structured to deliver returns with rising inflation aren’t available in the Indian market.

Floating-rate funds

So the better way is floating-rate bond funds. Inflation and interest rates tend to go hand-in-hand. Whenever inflation rises more than warranted, the Reserve Bank of India (RBI) increases short-term rates to control demand. The regulator has already begun the process by hiking policy repo rates by 90 basis points over two meetings.

Floating rate funds invest in bonds whose coupon rates are linked to benchmark interest rates. They tend to do well over the short term when inflation rates are higher.

So a part of retirement funds and that set aside for other short-term goals— especially those used for income generation—could be parked in these funds.

International funds

Rising inflation in the domestic economy can be a boon for international equity investors, whose foreign-currency investments get converted into more rupees. This happens because of the depreciation of the rupee against the dollar or euro.

However, investing just for currency arbitrage might not work (for instance, what if the business in a country suffers?). So, invest if you have a foreign currency-linked financial goal (like that of a child’s foreign education).

What about gold and real estate?

Gold is popularly considered the best hedge against inflation. However, over the years it has become too volatile and its record against inflation has been so-so. While property investors benefit from rising rent and property values during inflation, persistent inflation also hurts demand for properties as it did during the pandemic-fuelled downturn.

Historical context of inflation and what’s next

Any wealth creation strategy requires realistic assumptions on inflation expectations. It serves as the hurdle rate for the portfolio returns to cross in order to preserve wealth.

Consumer inflation has averaged 7 percent since the 1990s. In the past, India had witnessed high inflation due to the oil shock of 1973, when fuel prices soared by over 250 percent. With heavy dependence on oil imports, the country will continue to have its spillover effects whenever oil prices go up.

It might be prudent to factor in 7 percent consumer inflation while working out investment strategies.

Key takeaways

Adequate equity exposure is the best way to protect your portfolio from high inflationary threats. Ensure you don’t keep too much cash on the sidelines either.