Investing 101

Why investors may need to hedge their portfolios
against inflation

There are things in your financial life you can control – like the amount you save, and the amount you spend. But there are also external forces to be aware of, such as inflation.

Inflation – the phenomenon of rising prices (and therefore, less valuable dollars) – means that cash equivalent investments, such as money market funds or low-returning GICs, are the most vulnerable. That is, their low returns may not keep up with inflation.

Are we in an inflationary environment? Currently, the inflation level is low, as consumption – the amount of goods and services people buy – is still picking up following the recession. Without consumer demand creating scarcity of goods, it is hard to raise prices and cause inflation. However, inflation could be a concern in the coming years. The reason? Macroeconomics. When governments in the developed economies spent billions rescuing their economies during the recession, they incurred substantial debt.

According to Mackenzie Chief Investment Strategist Fred Sturm, this high debt leaves governments with a number of difficult choices: raise taxes, reduce services, make their economies far more productive or let inflation run higher. When inflation runs higher, dollars become less valuable. So, nations can pay off their debts in less valuable dollars.

Governments in most countries are motivated to get re-elected, and the inflation option is the easiest path, politically. “The sheer size of the debt problem may leave us with few options but to inflate our way out,” says Sturm. “This was the answer for the world after the Second World War, the last time debt burdens were so high. We suspect looking back five or ten years from now, it will have been a good part of the answer again. Our call remains to seriously consider the need for inflation protection within a balanced portfolio.”

Inflation protection is one element of your portfolio strategy, so it’s important to consider your complete picture before adding anything new to your investments. There are several categories of investments that are typically recommended: equities and equity mutual funds – especially companies with pricing power; real assets (including gold); and real return bonds, which have inflation levels factored into returns. All of these investment categories have associated risks and rewards. For example, real return bonds (or real return bond mutual funds) behave like long bond investments, and can be vulnerable to rising interest rates. That is, if interest rates rise, the value of the real return bonds can actually decline.

Your advisor can help you choose appropriate investments to provide a measure of inflation protection.