Incorporate Inflation Into Your Investment Strategy

Periodically, economic inflation becomes an all-consuming topic in the news. Most people understand that inflation is associated with higher prices and bad economic juju, but they don’t understand the nuances of this complicated economic topic – nor do they have any idea what to do about it.

The average American consumer is in no position to influence inflation in either direction through their investment decisions or actions (or even their votes). But you can incorporate inflation into your investment strategy to better protect yourself.

Let’s figure out how.

What Is Inflation?

First, let’s talk about what inflation is. Inflation is an economic phenomenon in which the value of a currency declines, ultimately pushing prices higher. If something costs $10 normally, and inflation weakens the buying power of the dollar, it’s only natural that the same product would cost more than $10 in the near future, proportional to the decrease of the buying power.

In other words, when a currency gets weaker, nominal prices rise.

The downstream effect of this is that things cost more money. Unfortunately, this increase in nominal pricing doesn’t apply equally; as most Americans can attest, prices of everyday consumer goods tend to increase much faster and more reliably than wages or salaries.

How does the value of a currency decrease? As you might imagine, there are many variables that need to be considered as part of this equation. But the most influential variable is the money supply – in other words, the amount of money in circulation. This should be intuitive; value is at least partially derived from scarcity, so if there’s more of a specific good in circulation, the value of the good decreases.

If gold were so common that everyone in the world could mine pounds of it from their own backyard, we would expect the value of gold to go down. Similarly, when the Federal Reserve enacts policies that precipitously increase the money supply, inflation is the natural result.

Inflation is a force you can anticipate, and you should include it in your strategic investment planning. You can try to take advantage of both high-inflation and low-inflation conditions – and hedge against inflation with your investments as well.

The question is, how?

The Influences of Inflation

Inflation has several effects on the economy.

  • Prices. The most notable influence is on prices. Most people acknowledge that inflation can influence the price of gasoline, groceries, and other household goods. But we also need to consider that inflation can influence the price of assets like stocks and real estate. Being able to time inflation carefully could enable you to buy assets at lower prices and sell them for higher prices.
  • Monetary policy. Inflation and monetary policy both influence each other. Aggressive, loose money policies lead to higher inflation, higher inflation leads to tighter monetary policy, tighter monetary policy leads to economic stagnation, economic stagnation leads to loose money policies, and the cycle continues again. Obviously, the cycle is not always this predictable or straightforward, but it often follows the same broad strokes.
  • Behavioral economics. At different rates of inflation, people behave differently, causing a litany of different economic effects. For example, when the effects of peak inflation begin to manifest, people begin spending less, which can cause a bear market.

Anticipating Inflation

Inflation is always a part of the American economy – and that’s by design. But the exact rate of inflation fluctuates in response to various economic and monetary variables.

Inflation is always here because monetary policy is designed to maintain a relatively low rate of inflation; inflation is believed by mainstream economists to be a good thing if kept under control. That’s partially because inflationary pressure in the form of gradually rising prices encourages people to spend more money, stimulating economic growth.

But if you’re going to take advantage of inflation, you need to know when and how the rate is going to fluctuate. Generally, inflation lags only slightly behind the actions of the Federal Reserve; during times of aggressive quantitative easing, low interest rates, and loose money policies, inflation gets higher. Conversely, during times of quantitative tightening, high interest rates, and tight money policies, inflation gets lower.

Inflation is too complicated a phenomenon to be reduced to such simple terms, but it’s a good general guideline to start with. Try to time your purchasing decisions and plan your high-level finances accordingly.

Hedging Against Inflation

It’s also a good idea to balance your portfolio to hedge against inflation; in other words, you’ll want to hold assets that balance out the risks you face during inflationary times.

These are some of the best ways to do it.

  • Invest early and often. Prices rise in inflationary environments, so the earlier you buy your assets, the better. Invest early and often to capitalize on this momentum.
  • Take advantage of loose money policies. Loose money policies are beneficial to those who take advantage of them; during times of lower interest rates, consider using loans and financial leverage to strengthen your portfolio.
  • Get into real estate. One of the best ways to apply this principle is to get into real estate; that’s because real estate is also a good hedge against economic inflation. Commercial and residential real estate alike can be valuable holdings in a properly diversified portfolio.
  • Balance with precious metals. Precious metals are often considered to be good inflation hedges, and for good reason. But their actual performance is a bit inconsistent, so invest with caution.
  • Consider other currencies. If your home currency is declining in value, consider investing in (and using) another currency. Currencies of strong economies are good bets, and you may benefit from investing in cryptocurrencies (as long as you do your due diligence).

Economic inflation can be annoying, or even devastating, because of its far-reaching effects. But if you can learn to anticipate inflation, and prepare your portfolio for it, you’ll be in a much better position to thrive in the long term.

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