Everybody has heard the word but few really know what it means. Before we can figure out how to profit from inflation we have to understand how it works. When you inflate a balloon, it gets bigger. For those with an inflated ego, well, we all know what that means.
Simply put inflation is a rise in the cost of stuff – your stuff, the nation’s stuff, and the world’s stuff – and much like your egotistical friend, it’s not a welcome sight. In order to keep up with inflation, one of two things would have to happen: either your employer has to give you a raise or the value of a dollar has to rise to account for rising import prices. As you know, neither of those happen very often. But there is a third way to deal, and even profit, from inflation. Invest in it. Here are three ways to so:
Inflationary Bank Products
Not all bank products will work to profit from inflation but there are some that allow you to use it to your advantage. According to the Wall Street Journal, some money market mutual funds are attractive in inflationary environments because they invest in products that mature in 30 to 40 days. If that seems a little foreign to you, the more often a fixed rate investment matures, the more your (or the fund that you’re invested in) opportunity to shop around for new rates that may be more in line with market conditions.
There are also products specifically tailored to investors who believe that the rate of inflation will rise. One example is a certificate of deposit that has varying interest rates. At the beginning of the CD period, the rate may be 2%. 3 years later, 4%, and by the time the CD matures, it may 5.25% or higher. While this type of CD laddering approach may seem like a sure way to profit, be wary of banks often give themselves the option to call the CD at certain time periods. This could leave the investor out in the cold if inflation falls making interest rates fall.
When you invest in a bond, you are a loaning a company, municipality, or the Federal government money in exchange for a set rate of return (coupon or yield). Although yields are constantly changing, the average consumer doesn’t buy and sell bonds frequently on the open market. For that reason, bonds should be seen as fixed income investments.
One type of bond that is specifically tailored toward profiting from rising inflation is TIPS. Treasury inflation-protected securities are essentially government-issued bonds whose principal grows with rising inflation and pay a fixed interest rate every six months, known as a "coupon," similar to ordinary Treasury’s. But unlike Treasury’s, TIPS are indexed against the Labor Department’s consumer price index. So when CPI – the measure of inflation – rises, the coupon payments of TIPS and the underlying principal automatically increase. Conversely, With a fall in the index, or deflation, the principal decreases. But rather than actual inflation, it is the expectation on inflation that drives the demand and price for TIPS. Such expectations could drive TIPS prices higher, thereby shrinking yields, since price and yield move inversely for bond securities.
Commodity prices tend to rise with inflation because they are in limited supply and are easier to pass to downstream consumers. For example, when the price of basic groceries goes up it is generally because the cost of raw materials that go into production of these items rose. But buying the physical commodity behind most goods is not practical for most people. Fortunately there are many practical ways to invest in commodities through stocks, ETFs or mutual funds.
Where to invest? First, invest in agriculture companies or funds (see Morningstar for a list of relevant funds). This includes seed and fertilizer companies, agriculture machinery companies, and companies who manufacture food. Food or other soft commodities like cotton and sugar, aren’t the only area to think about. Use exchange traded funds to invest in hard commodities like oil, gold, and other metals. If you think energy or gold prices are rising, then invest in a fund that owns these assets.
While inflation is still at historically low levels (around 1.5%), there is little doubt it is rising (just look at rising gas and food prices). So rather than wait to deal with higher prices take the smarter approach by saving and investing in an economy where real inflation is just around the corner.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.