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Lesson
2: How to protect your profits against inflation
Inflation is
the shrinkage in purchasing power of a currency as a result of price increases.
Inflation
cannot be predicted reliably and is not related to earnings or price.
Stocks are a
good hedge against inflation when inflation is between 0% and 6%. However, stocks
themselves generally do poorly during deflation and are erratic when inflation
exceeds 6%.
Investments
involving fixed principal and fixed income, like bonds, are adversely affected
by inflation.
So, invest in
stocks to protect against inflation at the normal 0% to 6% range. However,
because stock prices fluctuate, also carry bonds to anchor your portfolio.
Unfortunately, this anchor is susceptible to inflation too. Inflation erodes bonds. Watch inflation
carefully. It is unpredictable and very bad for investors.
Speaking from
an American perspective, TIPS are treasury bonds which increase with inflation,
so a good way to protect fixed income from the ravages of inflation. Another
advantage of TIPS are that they are exempt from state and local taxes, but not
federal tax.
Stocks are
not always available at a reasonable price nor do they always return as much as
bonds.
There is a
behavioural pitfall associated with inflation. If you receive a 4% pay increase
when inflation is 2% thus improving your position by 2%, you feel better than
if you receive a 2% pay increase when inflation is 0% thus improving your
position by 2%. Psychology is a critical factor in investing.
Between 25%
and 50% of your portfolio should include bonds simply as a means of
ameliorating the wild swings in stock prices. Hold most in stock because
stocks, though they carry risk, are your best way of fighting inflation.
Some hold “things” as a hedge against inflation such as precious metals, gemstones, commodities, collectibles, real estate and initial public offerings. Though there are striking price increases for gold and diamonds, these increases are unpredictable. Paintings by masters, first edition books, rare stamps and coins suffer from price unpredictability and an illiquid market. Avoid them. None are an effective hedge against inflation.
REITS can
protect you against inflation.
