Everybody now admits it: inflation is not transitory. It is here, it is really bad, and it will be here for a while. With interest rates still really low, bonds are a worse investment than they were last year, and they were bad then. The ten-year treasury has a yield of around 2.8% today. With inflation of 8.5%, this is a real yield of -5.7%! This means that if you purchase a ten-year bond and inflation stays at this rate, you are locking in a guaranteed loss of 5.7% on your money.
We can no longer ignore how bad inflation has gotten and investors need to make moves to fight back against it.
Inflation is almost always here ever since the Federal Reserve came into existence in 1913.
The annual rate of inflation since that time has been right around 3%. At 3% annual inflation, it takes about 24 years for the price level to double. But at 8.5% inflation, it only takes 8.5 years for the price level to double.
Inflation Can Eat Away at Portfolios
With inflation running at 8.5%, it is harder than it has been in decades to make a positive return. Let’s say the stock market turns around this year and returns 9%. After inflation that would be only a 0.5% annual return. This is way less than investors are used to. Put another way, in order to achieve the same real returns that investors have gotten over the past 40 years, the stock market would have to have a performance of more than 17% per year.
Inflation and Tax Issues
Another major problem with higher inflation is that investors are taxed on the gains that are due to inflation. For example, let’s say you have an investment property worth $200,000. Inflation is 3%, which means in 24 years the price level doubles. Let’s also assume the price of the property doubles as well, which means it just kept up with inflation. Well guess what: you have to pay capital gains taxes on the entire $100,000 gain. This is what is known as phantom capital gains taxes and it is a real issue for investments in real estate and stocks alike.
Inflation also adds to the value of investments in 401(k) plans and IRAs. Although this isn’t taxed right away, it will be eventually as you withdraw from the investments in the retirement account. The withdrawals will be taxed at your federal and state income tax rate. If you believe inflation will stay high and/or tax rates will increase in the future, it might make sense to look at a Roth IRA conversion. By converting now, you won’t have to worry about the future gains that will be taxed when you withdraw the money.
Investments for High Inflationary Times
Some people are surprised to hear that stocks are actually a very good hedge against inflation. When prices are going up, companies are making more revenue due to the higher prices. Higher revenue means higher future dividend payouts and thus a higher stock price. Keep in mind this is a long-term view. There are many years when inflation is higher than stock returns. But over long enough time periods, stocks have always beaten inflation.
Real estate is another great investment to have to beat inflation. Real estate is a tangible item, which means it generally moves with the overall price level. Many investors don’t have the funds or time to manage an actual property. This is where Real Estate Investment Trusts (REITs) can be a good investment.
A REIT is a fund that invests in multiple properties. It pays out regular dividends and usually has a very high dividend yield. Over the past 10 years, REITs have returned an average of nearly 11% per year. But be careful with these funds. Some have more debt than others and there can be tax complications with the dividend payouts.
If you are looking for one of the oldest hedges against inflation, gold is it. Gold has outpaced inflation easily over the past 20 years, averaging a return of 9.5%. Note though that if you buy physical gold you would have to worry about storing it and gold prices are notoriously volatile. You can also invest in gold funds such as GLD, which theoretically will perform the same as physical gold over time.
Treasury Inflation-Protected Securities (TIPS)
Treasury Inflation-Protected Securities (TIPS) were created to ensure that investors will get the rate of inflation added to the yield on the bonds. Currently, the TIPS yield is negative, which means investors still will not beat inflation. But they come very close since they add the lagging inflation rate using the Consumer Price Index (CPI).
One problem with using TIPS is that the inflation adjustment is taxed as income. Also, if there is deflation the value of the securities can actually decrease over time.
Beware Of Bank Accounts and Money Market Funds
Most bank accounts and money market funds pay less than 1% per year these days. Some are at 0%. This is very dangerous when inflation is high because the real value of the investment money declines every day. In one year, if you are earning nothing in a bank account, you will lose 8.5% if inflation stays where it is. This is why it is so important to look at other types of investments that provide a good hedge against inflation.