Investing, Treasury

Lesson 2: How to shield profits from inflation

If your natural instinct is to leave those hard-earned profits in a low-interest bank account or bet it all on a wild 'deal-of-a-lifetime', stop. Your instinct is not serving you well. Investing for Entrepreneurs is a short educational series based on the work of Benjamin Graham. It’s value investing to be sure but synthesised into twenty bite-sized tasters to satisfy the hungriest entrepreneur. The end result of applying what you learn here, we trust, is genuine financial security.

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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.

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