First things first, what does “hedge against inflation” actually mean? It's an investment strategy designed to preserve purchasing power, even as the value of the currency upholding the investments dwindles over time as a result of inflation. In other words, a house you bought in 1970 for $30,000 has likely maintained its value or may have even surpassed it.
Today, that house is most assuredly worth significantly more than its original purchase price. If it increased in value to $210,000, about seven times the original price, then it's kept up with inflation, and the home's value in today's climate has remained steady.
For an investment to be a true hedge against inflation, its future valuation must outpace the rate of inflation. Inflation is not a new phenomenon, and nearly every monetary expert foresees it occurring indefinitely. Therefore, it must be taken into account when planning a long term investment strategy. Historically, some asset classes tend to perform better than others in periods of rising inflation, just as some outperform when interest rates fall, and others fare better in the early stages of an economic recovery.
Take stocks for example.
Over all, inflation-adjusted returns for stocks are positive (U.S. large-cap stocks outpaced inflation 86% of the time, over rolling 10-year periods since 1926). Tread with caution, however, since past performance doesn’t necessarily guarantee future results.
Interestingly, some stocks appear to benefit more than others when inflation picks up. For instance, large value and developed international stocks have shown more positive correlations to inflation over the past few decades. This brings us to another phenomenon about inflation: it isn't steady, and it's difficult to predict the rate at which it will occur in a given year.
Are you getting mixed signals yet? Don't worry. It's not just you. So what can investors do to prepare themselves for the wild card that is inflation?
Thankfully, the answer is relatively simple: Avoid trying to figure out the “best” investments for inflation protection. Instead, diversify. Own the whole market at all times. True diversification is broad. It doesn’t mean you just own lots of stocks. It means you also own several asset classes –– in addition to those stocks.
Adequate diversification is key. It protects yourself from catastrophic losses if something goes wrong with a single stock or asset class. Equally important, it also ensures your exposure to profitable outcomes in any and all inflationary climates.
