How to Profit From Inflation

Inflation can make investing challenging if you're not prepared for it, but several investments tend to fare well during periods of rising inflation. Commodities, inflation-indexed bonds, Treasury Inflation-Protected Securities (TIPS), and consumer staples are all investments that maintain value and generate returns throughout economic fluctuations.

You can also invest in real estate, mortgage-backed securities, and collateralized debt obligations through exchange-traded funds, but these are risky investments.

How Is Inflation Measured?

Inflation is a measurement of the change in prices of goods and services. It is expressed as a rate in percentage form and indicates how much prices have changed from the last time it was measured. It may seem counterintuitive to promote inflation, but a moderate inflation rate is good for an economy because it promotes growth, lending, and borrowing.

The U.S. Federal Reserve targets a 2% average inflation rate over time as most consistent with its dual mandate in promoting price stability and maximum employment. Several agencies specifically choose the prices of goods, services, and influencing factors to measure the inflation rate.

Inflation Indicators

The most common economic measurements used to gauge inflation are the Consumer Price Index (CPI), the Producer Price Index (PPI), and the Personal Consumption Expenditures Price Index:

• The CPI measures the weighted average urban consumers pay for a standardized market basket of goods and services. It is reported monthly by the Bureau of Labor Statistics (BLS).
• The PPI is a weighted average of prices realized by domestic producers. It includes prices from the first commercial transaction for many products and some services. It is also reported monthly by the BLS.
• The PCE Price Index is the Federal Reserve's preferred inflation gauge. The PCE is a broader measure than the CPI and is weighted based on consumption measures used to derive the gross domestic product rather than on a household spending survey as the CPI. It is released monthly by the Bureau of Economic Analysis of the U.S. Department of Commerce.

All three of these indices provide an alternative "core" reading, excluding the more volatile food and energy prices. Another alternative inflation measure is the Trimmed Mean PCE Price Index from the Federal Reserve Bank of Dallas, which excludes from each monthly calculation spending categories with the most extreme price moves in either direction.

Investable Assets for Inflation

While inflation's effects on the economy and asset values can be unpredictable, history and economics offer some rules of thumb.

Inflation is most damaging to the value of fixed-rate debt securities because it devalues interest rate payments as well repayments of principal. If the inflation rate exceeds the interest rate, lenders are, in effect, losing money after adjusting for inflation. This is why investors sometimes focus on the real interest rate, derived by subtracting the inflation rate from the nominal interest rate.

The assets that fare best under inflation are those assured of bringing in more cash or rising value as inflation increases. Examples would include a rental property subject to periodic increases in rent or an energy pipeline charging rates tied to inflation.

Real Estate

Real estate is a popular choice because it becomes a more useful and popular store of value amid inflation while generating increased rental income.

Investors can buy real estate directly or invest in it by purchasing shares of a real estate investment trust (REIT) or specialized fund.

Real estate fared particularly well during an outbreak of persistent inflation during the 1970s. But real estate is also vulnerable to rising interest rates and financial crises, as seen in 2007-2008.

Commodities

When inflation picks up, investors often turn to tangible assets likely to rise in value.

For centuries, the leading haven has been gold—and, to a lesser extent, other precious metals—causing prices to rise as inflation rises. Gold can be purchased directly from a bullion or coin dealer or indirectly by investing in a mutual or exchange-traded fund (ETF) that owns gold. Investors can also get exposure to a commodity by purchasing shares of the companies that produced it directly, or indirectly through an ETF or specialized mutual fund.

Commodities include raw materials and agricultural products like oil, copper, cotton, soybeans, and orange juice. Commodity prices tend to rise alongside the prices of finished products made from those commodities in inflationary environments.

For example, higher crude prices elevate the price of gasoline and transportation. Sophisticated investors can trade commodities futures or the shares of producers. On the other hand, exchange-traded funds investing in commodity futures will tend to underperform the price of a rising commodity because their futures positions must be rolled as they expire.

Bonds

Investing in bonds may seem counterintuitive as inflation is typically harmful to fixed-rate debt. That's not the case for inflation-indexed bonds, which offer a variable interest rate tied to the inflation rate. In the United States, Treasury Inflation-Protected Securities (TIPS) are a popular option, pegged to the Consumer Price Index.

When the CPI rises, so does the value of a TIPS investment. Not only does the base value increase, but since the interest paid is based on the base value, the interest payments increase with the base value increase. Other varieties of inflation-indexed bonds are also available, including those issued by other countries.

Inflation-indexed bonds can be accessed in a variety of ways. Direct investment in TIPS, for instance, can be made through the U.S. Treasury or a brokerage account. They are also held in some mutual funds and exchange-traded funds. For a more aggressive play, consider junk bonds. High-yield debt—as it's officially known—tends to gain in value when inflation rises, as investors turn to the higher returns offered by this riskier-than-average fixed-income investment.

Stocks

Stocks have a reasonable chance of keeping pace with inflation—but when it comes to doing so, not all equities are created equal. For example, high-dividend-paying stocks tend to get hammered like fixed-rate bonds in inflationary times. Investors should focus on companies that can pass their rising input costs to customers, such as those in the consumer staples sector.

Loans/Debt Obligations

Leveraged loans are potential inflation hedges as well. They are a floating-rate instrument, meaning the banks or other lenders can raise the interest rate charged so that the return on investment (ROI) keeps pace with inflation.

Mortgage-backed securities (MBS) and collateralized debt obligations (CDOs)—structured pools of mortgages and consumer loans—respectively, are also an option. Investors do not own the debts themselves but invest in securities whose underlying assets are the loans.

MBS, CDOs, and leveraged loans are sophisticated, somewhat risky (depending on their rating) instruments, often requiring fairly large minimum investments. For most retail investors, the feasible course is to buy a mutual fund or ETF that specializes in these income-generating products.

Pros and Cons of Investing for Inflation

There are pros and cons to every type of investment or hedge. The primary benefit of investing during inflation is to preserve your portfolio's value. The second reason is that you want to keep your nest egg growing, even if it's at a slower rate.

Accepting inflation as a necessary condition of a growing economy—and thus investing gains—can lead you to diversify your holdings to account for times when one asset type loses value and another gains it.

Spreading the risk across various holdings is a time-honored method of portfolio construction that is as applicable to inflation-fighting strategies as it is to asset-growth strategies.

The Bottom Line

There is an old saying, "The inflation tail should never wag the investment dog." It still rings true because changing strategies and reallocating during times of high inflation can cause more losses than if you weather the inflation storm.

Set your investing goals and timetables for your investment plan, diversify, and don't swerve. And remember, there are no guarantees when you're investing. Traditional inflation hedges don't always work, and unique economic conditions sometimes deliver excellent results to surprising assets.