One of the first things we do when we want to be more financially prudent is to set aside savings for rainy days or enlarge our existing emergency funds. When we do this, we’re mainly giving ourselves the ability to tide through unexpected life events in the short-term, such as losing a job, taking time off to look after a newborn or unwell loved one and even a sabbatical to pursue new interests or start a business.
While this provides a safety net, we cannot ignore the risks of just letting our money sit idle in a bank account returning measly interest rates. This is because inflation will constantly be eating into your spending power.
What Is Inflation?
Inflation is the general increase in the cost of living over time. In other words, each dollar you have today would be worth incrementally less in the future. This means our basic needs such as bread, milk, healthcare, home, education and even haircuts will continue to increase in prices.
The main problem with inflation is that we’re not able to buy a loaf of bread today to consume in our retirement. If we want to eat a loaf of bread in our retirement, we have to pay what it costs at that point in time.
So, if we want to ensure our $2.40 today is still able to buy a loaf of Gardenia bread in 10 years, we have to invest it, and grow it by at least the rate of inflation.
Read Also: An Simple Example Of How Inflation Works
Here are four investments that can help act as a natural hedge to inflation. Before going into it, you should also note that when we invest our money, we always run the risk of not earning the expected returns or losing money.
# 1 Gold
Gold is perhaps one of the first investments that come to many of our minds when we hear the term inflation. For many years throughout human history, the role of gold has been to preserve wealth. When there is significant uncertainty in markets, including times of heightened inflation, people flock to gold to be able to store their wealth than let it erode via fiat money (paper money).
For many of us, inflation is only truly visible in the long-run. This analogy hopefully clarifies how gold hedges against inflation. Imagine if we pay for bread in gold: at a price of $2.40 today, one loaf of bread would be worth approximately 0.39 grams of gold. In 30 years, the current price ($2.40) should logically should not be able to buy a loaf of bread. However, if we had 0.39 grams of gold, which is worth one loaf of bread today, we would very likely be able to purchase a loaf of bread in 30 years.
Real estate can also be a good hedge on inflation. This works when you think of real estate as a commodity, to live in, work out of and participate in leisure activities at. As inflation drives up the price of goods and services, the price of this commodity should also rise in tandem.
Inflation not only affects the prices of goods and services, but also the wages of employees to be able to still afford those goods and services. This means that as long as there is demand for a certain property, it will likely continue to act as a good hedge against inflation.
#3 Individual Businesses (And Stocks)
When we invest in companies, we aren’t just blindly hoping to make money. The reason we are able to make money is because when inflation occurs, businesses have to remain profitable to survive, and thus have to pass on increasing costs to consumers.
This is the same for private companies or those listed on stock exchanges.
Take the loaf of Gardenia bread again: the reason why it is retailing at $2.40 today is because that price point allows the manufacturers and distributers to make a profit. If these businesses are not able to make a profit on it, they would either not sell the product anymore or have to increase prices to be able to earn a profit.
This is why it is so important to thing about a company’s long-term sustainability and advantage in the market when it comes to investing in its stocks.
#4 Stock Indexes
Stock indexes, such as Singapore’s Straits Times Index (STI), Hong Kong’s Hang Seng Index (HSI) or USA’s Standard & Poor’s 500 (S&P 500) Index are comprised of the strongest businesses listed in the country. This means you’re not only investing in a business, but you’re investing in a pool of the strongest businesses in the country.
Moreover, the index is continually reviewing and making adjustments to which companies qualify to be part of it. This makes it better able to survive not just inflation, but only the idiosyncratic risks every company faces.
Why Inflation Matters
As mentioned, inflation is one of the biggest risks each of us face when building our retirement portfolio. Many of us in today’s generation might brush off inflation simply because it hasn’t hit us hard enough. Even for the generation before us, while inflation spiralled, their wages and net value also soared.
When we eventually retire, we cannot expect our property or stock value to soar as much as it has over the past 30 years in Singapore. This just means we need to pay closer attention to how we’re building and maintaining our retirement portfolio.
If you believe there are other natural hedges against inflation, do share your thoughts on our Facebook comments section.