How to invest in stocks and bonds to hedge against inflation

If inflation rates surpass projections, most major asset classes are likely to experience setbacks. Nevertheless, when looking at a more extended time frame, you have the opportunity to strategically align your portfolio for optimal performance during a period of escalating prices. Read on for more insight on how to invest in stocks and bonds when inflation is skyrocketing.

When you take a look at stock market performance over an extended term, it embodies a compilation of companies, with numerous reputable ones boasting loyal customer bases and a level of pricing influence. For investors, this implies that such well-established companies are likely to sustain profitability, even amid inflationary conditions.

Certainly, individual companies may encounter challenges — for example, if their cost of goods sold rises at a rate that is difficult to sustain. This is inherent in the capitalist system, where some companies thrive while others face difficulties. For this reason, we recommend having a diverse range of companies in your portfolio, whether through a well-rounded selection of individual securities, a cost-effective mutual fund, or an exchange-traded fund (ETF). In essence, maintaining a portfolio of high-quality stocks is likely to offer the best chance of keeping up with inflation in the long term.

Below is a chart that compares the years with the highest inflation rates, from the highest to the lowest, along with the corresponding S&P 500’s return for each year. As shown below, both inflation rates and the stock market return can really fluctuate from year to year, but the data below offers compelling proof that stocks — particularly investing in the S&P 500 — can serve as one of the best hedges against inflation in the long run.

Source: A Wealth of Common Sense

One particular category of stocks that have done well in periods of inflation is natural resources. Companies operating in sectors like gas, oil, agriculture, farming, and metals have historically demonstrated resilience during periods of inflation. This can be partially attributed to the fact that the commodities these companies sell often experience price increases in tandem with inflation, leading to augmented revenue that can offset rising costs. Including natural resource companies in your portfolio might be a prudent strategy, especially in the presence of persistent inflation.

However, some important considerations are also worth noting. When we refer to natural resources, we are specifically addressing companies within these industries. We highly discourage investing directly in the raw materials themselves because of their unpredictable nature and the difficulty in precisely tracking their underlying price changes. Moreover, when considering investments in natural resource stocks, it’s essential to carefully size your investment. These companies form only a small fraction of global corporations and should only make up a modest portion of a diversified portfolio. Overemphasizing any sector — including natural resources — is rarely a prudent approach.

Bonds are the most common type of fixed-income investments. The primary risk for fixed-income investors, excluding default, is inflation. This is because the returns on most bonds are "fixed" as the name suggests, resulting in diminished real purchasing power over time as inflation rises. As a result, bonds are sensitive to changes in actual or expected inflation rates, but being in a high inflation environment doesn't necessarily mean avoiding investing in bonds altogether. Bonds, generally less volatile than stocks, offer diversification and relative stability, making them a suitable component of many investors' overall portfolios.

The key is to hold the right types of bonds. In times of inflation, the most significant losses typically occur in bonds with longer maturities. This is logical because inflation has a greater potential to erode purchasing power over extended periods. Therefore, in both inflationary and non-inflationary environments, investors are encouraged to prioritize bonds with short- or intermediate-term maturities when constructing their portfolios. This approach generally allows investors to capture the majority of bond market returns while also managing inflation and interest rate risks.

The spike in inflation has generated heightened curiosity in I Bonds overall. The U.S. Treasury issues I Bonds with a 30-year maturity, offering interest determined by a blend of fixed and inflation rates. At the time of this article’s writing, the rate is 5.27% for I Bonds issued from November 2023 through April 2024.

Pros of investing in I Bonds:

• The return is guaranteed by the government

• Interest earned is exempt from state and local taxes

• Interest earned is taxed at the federal level as ordinary income, but it can be federally tax-exempt if used for higher education expenses if you fall within the required modified adjusted gross income (MAGI)

Cons of investing in I Bonds:

• For the initial 12 months, they lack liquidity entirely, and if you redeem them within the first five years, you forfeit three months' worth of interest

• The limit for purchasing I Bonds is $10,000 per year, with the option to add $5,000 using your tax refund

The most crucial factor to consider during periods of rampant inflation is to overlook the market volatility associated with inflation and adhere to a well-diversified portfolio set up for success over a longer time horizon. While your portfolio may experience short-term volatility, it is designed to pave the way for long-term success, even with sustained consumer price increases. An experienced financial advisor can help tailor investment strategies that not only hedge against inflation but also ensure a diversified and resilient portfolio for long-term financial goals.