How investors can protect against inflation

How investors can protect against inflation

The Social Security Administration’s announcement on Oct. 13 of a 5.9% cost-of-living adjustment (COLA) for benefits in 2022 may have come as a surprise to many. After all, the U.S. consumer price index for all urban consumers (CPI-U) on which the COLA was based had maintained average annual increases under 2.5% since 2012 until ramping up this year.

CPA financial planners interviewed agreed that the majority of investors probably don’t need to make any drastic inflationary hedging moves.

For one thing, many analysts doubt that the country is entering high or protracted inflation. The Federal Reserve’s Federal Open Market Committee (FOMC) Summary of Economic Projections on Sept. 22 cited the U.S. Department of Commerce Bureau of Economic Analysis’s personal consumption expenditures price index in predicting that inflation will fall back to 2.2% for 2022 and 2023 and 2.1% for 2024. However, others might regard that forecast with skepticism, considering that the FOMC in its December 2020 summary projected that inflation this year would be only 1.8%.

For another thing, the majority of investors, who generally are saving for retirement, are better off keeping their eyes on a longer time horizon than inflationary cycles generally run, CPAs said.

“When we’re investing for clients, generally speaking, we’re investing for long periods of time,” said Michael Goodman, CPA/PFS, president of Wealthstream Advisors Inc. in New York City and co-chair of the AICPA & CIMA Personal Financial Planning Summit. “And we don’t expect inflation to be a long-term issue.”

Likewise, Chris Benson, CPA/PFS, with L.K. Benson & Co. in Baltimore, said the prospect of higher inflation shouldn’t necessarily cause advisers to change their investment strategy.

“I don’t think anyone knows how long the current inflationary period will last or how bad inflation will be,” Benson said, adding that the current increase is thought to be due to circumstantial factors that could well be transitory, specifically, COVID-19-related business shutdowns and supply chain disruptions. Even if it persists, “we still don’t know exactly how it would impact different asset classes.”

Still, even temporary, mild inflation can erode the value of many assets and any fixed income they yield. Retirees and others depending on their investments for current income may see more sense in hedging. A diversified portfolio typically includes some assets that perform better than some others during inflationary times. Benson said clients have been asking for months what they should do about inflation and in some cases have increased their holdings of such assets. TIPS and CIPS

One instrument specifically designed as an inflation hedge is Treasury inflation-protected securities (TIPS), which have been offered since 1997. The principal of TIPS increases with inflation as measured by the CPI-U (and decreases with deflation). TIPS also pay semiannual fixed interest, typically well below that of ordinary Treasury bonds. They may be held to maturity or sold on the secondary market. Treasury offers them in both competitive and noncompetitive auctions, with maturities of five, 10, and 30 years. Some corporate bonds also include an inflation-protection feature (CIPS). For more, see ” TIPS and CIPS ,” JofA , Jan. 2007.

TIPS make sense, but only in a conservative strategy, and even there probably not as a primary position, Benson and Goodman said.

“We don’t buy individual bonds for clients but do generally have an allocation to a TIPS fund, especially for retirees who are drawing down on their portfolio,” Benson said.

“There’s no question TIPS are a good hedge,” Goodman agreed. “But it’s just going to protect your bond position or your shorter-term cash need positions. You’re not going to get the growth you need in excess of inflation.”

Real property has also been long considered a refuge from inflation, although most investors won’t be looking to purchase buildings and land, which carry their own risks and volatility, or “noise,” as Goodman termed it. Rather, positions in mutual funds and exchange-traded funds (ETFs) investing in real estate are generally more feasible and predictable, along with real estate investment trusts (REITs), and may provide some of the perceived inflation protection of the underlying property interests.

REITs “are another asset class that we include in almost all client portfolios,” Benson said. But, he said, “The correlations are weak between nominal returns and inflation for REITs, and the research is mixed as to whether they will always provide protection in an inflationary environment.”

With COVID-19 still prompting many office workers to work from home, the outlook for commercial real estate could be a concern, but some cities are showing improvement in that sector, he added. “A diversified fund like the Vanguard Real Estate ETF […]

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