The Right Way to Hedge Against Inflation Risk

Inflation

Inflation eats away at all assets, where it gets deducted off the top from our assets. Inflation going up is a concern to many, but the best way to beat it is to just beat it.

Inflation risk in principle applies to all investors, although it is more of a concern to those who shoot for returns that don’t really have the potential to beat inflation very much. This is particularly the case with a lot of older investors who have been given a roadmap that makes inflation a bigger beast than it needs to be, trying to manage this with investments that not only don’t reduce their risk, they end up increasing it instead.

We will never get past this worry unless we actually choose a path that actually puts us in a position to succeed rather than resigning to one that is pointed toward failure instead, where we’re left to only being able to make minor changes and still stay within the philosophy of our approach. When the philosophy itself misses the mark by so much, the only way out is to re-think things completely.

The only place to start this journey is to throw away all of our current ideas and start from scratch, and not being able or willing to do this is the fundamental reason why investors are unable to get even to square one in this process, and the ideas that are serving as millstones around our neck will continue to weigh us down so long as we refuse to even examine them.

If we want to manage inflation risk, we need to start by looking at risk overall when investing, as this can never be about focusing on one particular type of risk to the exclusion of the proper consideration of other risks that we may face. If we’re looking to achieve certain income goals in retirement for instance, the most basic and most prominent risk is simply our failing to reach our goals, because that in itself will mark our failure.

Income here needs to be broadly defined, and while that might seem obvious, in the confused world of investing, there are actually a lot of people who think this means fixed income, which is not only foolish but in itself takes them off the right path, never to return.

When we’re looking to save for retirement, or if we are already there and are trying to make our money last, we first look to our needs to decide how much we will need, and then work our way backwards from this to decide what we will have to do to achieve this income goal. This is the top-down approach, and while we also need to look at the bottom-up approach to this, choosing strategies and then looking to project income, this will always involve comparing what we expect to get with what we need or want, so these needs or wants always need to play a central role in our decision making.

We may think that we’re using a top down approach with saving for retirement, and this is the first thing a financial planner will ask you, but in practice, we don’t just use a bottom-up approach instead, we limit this approach by only looking at certain ways to achieve it and exclude others, without any real consideration of need.

There are a few key reasons why we make this mistake, with the misunderstanding of what qualifies as income only being one of them. This all happens as a matter of exclusion, where we just proclaim our preference for fixed income and then exclude other ways of making money to help us. We then select from among these options, with no real regard as to how well our how badly this will serve to improve our situation and even achieve our most basic needs, and in many cases, disallow any outcome but abject failure.

Inflation risk falls within this category of failing to achieve our investment objectives, where we have to account for the risk that we’ll need even better returns to get to the same place that we need to be. Inflation devalues the future value of money, and we want to account for how much it may be devalued lest this in itself keep us from getting where we need to be.

It might seem strange indeed that people would worry about inflation risk and not really pay much attention at all to the greater risk of just not getting there regardless, but in the crazy world of investing, foolishness is the norm, not the exception. There may be nothing so foolish as the way we direct people’s retirement savings, and these are the people who are least able to bear these mistakes since their very livelihood is at stake.

Among the risks involved here is having to wrestle with the unforeseen, and in our senior years, the risk of this goes way up. This is particularly the case in the United States, where even with insurance, health care costs can be a huge burden, and this is the age where people get burdened the most, by far.

There’s a certain number that we will need to get by exclusive of these events, and while we really need a good buffer against unplanned expenses, we at least have to make it to the point where we will be all right in the best of circumstances. Getting there needs to be our first priority, or if we’re unable to get there, our coming as close as we can becomes the overriding goal.

None of this should even be subject to debate, as whenever we say that we need or want a certain amount of money per month in retirement, we have proclaimed its priority ourselves. This is the most basic thing to strive for, and if and only if we can comfortably reach this point does other considerations come into play.

Inflation Eats Away at Nest Eggs, Especially Smaller Eggs

This sets the stage for everything, and if for instance we are worried about inflation eating our future income, but we choose a path that in itself limits where we will end up on a net basis, we are choosing to be harmed instead of benefited.

If we choose a plan that provides a much lower rate of return than we may achieve otherwise, by holding gold for instance which is well known as a good hedge against inflation, gold may go up in value as inflation moves up, but what we end up over time can be considerably less, where the hedge hasn’t protected us, it has harmed us.

The great majority of older people need to be swinging for the fences, not try to bunt. When a foolishly conservative path guarantees our failure, this is not the time to continue to exclude any other possibilities. It won’t help you much to strive for a level of income that will have you suffering and then worry about that being degraded further, and then refuse to do anything about either problem.

If you already have all the money you want and just want to protect from inflation taking you from enough to not enough, becoming what they call conservative at least might make some sense, even though this involves ignoring the overall picture and paying the price for it. This at least has us succeeding in achieving the level of comfort we seek though, no matter how much money that we leave on the table as our price for this.

Another big mistake that is made is to assume that we need to decide things well in advance when such a need simply does not exist. Worrying about inflation right now is a perfect example of this, with inflation so low, and we really do not want to be hedging against something that isn’t here, like worrying about how you might protect a million dollars when you are broke.

The biggest mistake investors make though, by far, is to worry about market risk when it doesn’t exist, and being willing to sacrifice a lot of returns to feel protected against a threat that really doesn’t exist, but when it does emerge, like it sure has lately, we stand by and watch our portfolios get attacked. It wasn’t the time to act before, but we did, and now it is time, but we don’t.

It is important to have a contingency plan for contingent events, but to be acting as if the event is already occurring and looking to protect against it now, and paying a price to do it, just does not make sense.

People have hedged against a bear market throughout the entire bull market, and many now even think that was wise. If we are optimizing for returns, that’s not hedging because hedging requires us to sacrifice returns for risk management, but without the risk, all you have left is the sacrifice of returns.

People do this all the time with investing, to cut our returns dramatically because they are worried that the rain may come and they may become turned to pillars of salt by the investment gods and will not be able to run for cover. If someone from another planet visited us, this is how they might describe the way we invest overall, and the description would be alarmingly accurate.

This is exactly what we have seen happen with this recent bear, with most investors, even those who don’t have a lot of time left, fiddling while Rome burns. Their predictions have come true, they haven’t been able to deal with crisis, and instead have relied on just investing less in stocks to limit the damage, but have allowed the move to place their retirement in even more jeopardy, when the goal was supposed to try to protect it.

Hedging against high inflation in a very low rate environment, which many people do, by choosing investments that may do better in inflationary times but we are not at such a time, will put the hurt on us as well, although the magnitude of the harm this causes may not be so transparent. It wouldn’t matter anyway because if you don’t think about such things, the only thing you will notice is your failure.

Even then you still may think that you did what you could, because you are completely in the grips of the idea that hedging when you don’t need to is a good idea, and this list includes the overwhelming majority of individual investors. Commonplace investing ideas and assumptions is a lot like a cult, and with just about everyone being believers, and with just about no one even questioning their beliefs, their fears and disappointments will not point to the real source of their problems because their beliefs are so powerful that they become immune to reasoning.

If we had to pin down the problem to one thing, it is the distortion of time that does people in the most, by far perhaps, and this applies to investors of all shapes and sizes, including those saving for retirement.

The distortion of time involves becoming so preoccupied with the future that we ignore what the best approach would be to manage these risks and instead choose to pretend they exist when they do not. Inflation risk is once again a perfect example of this, but this certainly applies to investment risk as well, in full measure.

It is not that we do not want to account for what happens if inflation becomes high once again, and then may think that if it doubles from here, we may be in trouble, and then look to hedge as our solution. People need to understand what a hedge is supposed to be doing, and once they do, the error of this thinking should become obvious.

Let’s say that we look at the sky and see it perfectly clear. There is not a single cloud in it, nor do the weather forecasters predict any. This would not be the time to wear a rain suit and sweat in the sun as well as having those big rubber boots impede our progress.

Why would we then worry about inflation risk when there isn’t an inflation cloud in the sky? What would we be protecting ourselves against here? Hedging is always about improving the risk to reward ratio overall, but this just sacrifices rewards with no benefit.

That makes no sense, even though we may think that no one would be fooled by such a thing. Many are, but with inflation risk, the main problem is that people are told to take on a lot more inflation risk by investing in bonds and then needing to deal with the problems this creates.

Bonds Have their Place, But Have Low Returns and Are Very Prone to Inflation Risk

While we may worry about our income in retirement being diminished by inflation, we get a double whammy when our money is in bonds and inflation is going up. Inflation and bonds are inversely correlated, so you not only lose to inflation, your investments hand you a double loss.

We do not have to even wait until inflation goes up very much start paying the price here, as every incremental rise in inflation will bring pain to our portfolios. With rates so low, where they can only go up and work against us, bonds may be a nice place to visit in the right season, but we should never want to live there, especially these days with this longer-term risk so high.

A lot of investors want to get married to their investments though, and this is certainly true of older investors, where they may even see the risk but wish to still cling to the risk to a considerable degree. If inflation is rising, bonds are the slums, and while we may want to brighten up our shanty by slapping a little paint on it, we need to ask ourselves why we prefer this part of town in the first place.

Bonds themselves are supposed to be a hedge, and we give up a lot here versus the average return of stocks for this hedge, we certainly aren’t getting any inflation protection when we don’t need it, and we have not needed this for a long time now. Sure, they have helped cut people’s losses at a time like this, but this is a good idea only if you think that’s the only way to do it. Just selling your stocks at these times isn’t even in the playbook.

Diluting our returns over time needlessly isn’t the only worry though. If you insist on making this worse by deciding to hold a high percentage or any amount for that matter regardless of how much they decline in value by way of inflation, you are headed for even more trouble.

Given that bonds are treated as an idol by so many investment advisors and investors alike, it is not surprising that so many people are looking ahead to what will happen when inflation rises and still wish to hold on to a large portion of their bond positions regardless, because whether or not this even makes sense has not even occurred to them.

The best and only sensible way to hedge against inflation risk with bonds is to simply not be in bonds when inflation is rising, not that we should ever want to be in them when they are in a downtrend. They have been in a strong uptrend lately, but this won’t last. This is not just about managing this particular risk, it is also about not wanting to be in something that is expected to go down in value.

If you need a certain amount of money in retirement, and you’re worried that you will need more than expected returns due to inflation going up, the last place you want to be is in bonds as you both see the fixed interest that you are receiving lose value, you see the value of the bonds themselves lose value. There’s 2 parts to bonds, and when both are against you, this is not to be desired.

Many people understand that bonds have a high degree of inflation risk, but the part that they miss is that this in itself renders then undesirable in times of rising interest rates, although bonds as a blanket strategy is a very bad idea in the first place for those who are not comfortable already, and even with those who are not, since this serves to smother our returns.

If inflation is rising, when it does that is, this is not the time to be in bonds at all unless there is a good reason to, which means that their value is rising in the short term and can be relied on as good investments right now relative to other choices. Other than that, if the inflation tide is rising, we will mostly want to be out of them, not in them full-time, in any amount.

We can therefore settle the burning question of how we should manage inflation risk with bonds by just avoiding them when the risk of this becomes significant. The funny thing is that people are worrying about this now, when it isn’t even going on, and are moving to cash more even as bonds have increased in value over the last while.

We might actually be in store for some inflationary pressures as the coronavirus hangover kicks in, and those exposed to bond risk will continue to pay the price for it, and needlessly so.

Cash can sometimes be the best place for our money, and is certainly preferable to hold over bonds with inflation going up, but is rarely preferable overall, as there is usually a better place to have our money. Investors are being pointed more toward cash these days, as well as toward dividend stocks, a rather odd-ball combination, but it seems to them that the fact that a stock may pay a higher dividend is a sensible way to pick stocks, as well as their assuming that if there is a good enough dividend, that in itself makes it suitable for these investors.

It turns out that the best way to hedge against our income being depreciated is to just make more money. Even needing to say such a thing is pretty amusing in itself, but the need here is great as it turns out.

The actual joke in this story is how people focus on interest or dividend payments to the exclusion of everything else, including how much money they will end up with net of inflation. We would think that how much you end up with would be at least noteworthy enough to be some sort of consideration, not something that is simply ignored.

The proper approach involves realizing that if we are looking to feed the livestock on our farm, we need to make hay while the sun shines so we can be comfortable when it rains. If we instead choose to grow much lower yielding crops, this is when we need to worry what will happen to us if the weather turns bad.

If we are just thinking about interest payments though and not enough about making money, this can happen pretty easily it would seem. There are several banes of investing, but this is definitely one of them.

If we really want to manage inflation risk, we need to replace the concept of income with that of profit, because our income in retirement is entirely dependent upon the amount of profit we achieve and we definitely should not want to forget about our cow if we want milk, because that’s where it comes from. The cow in this story is our investment profits, and if we’re looking to milk it in retirement, being happy with it being so scrawny doesn’t make sense.

Our profit is what is eaten away at by inflation, and if we want to have more over once inflation takes its turn, we are going to need a bigger pile.

How we may best optimize our profits while also properly and not indiscriminately manage risk is a separate issue, although to even make travelling down this road possible, we have to make this not just a goal but the goal period.

Having our minds opened to the fact that since the goal of investing generally is supposed to be making money, we should actually adopt it ourselves, arming ourselves properly for all the potential monsters out there in the future, including inflation going up. We do not just want to see these monsters much bigger than they are, and just flee from them, as under closer examination they are much smaller and can be slain far easier than we may think.

Meanwhile, we see so many investors lost in this forest, where we just invest without even questioning the relative profitability of what we are investing in. We then buy things like stocks for dividends or bonds for interest payments, or bonds to hedge against inflation and market risk, without even being curious enough to even wonder if we’re doing the right thing or whether this is the time to be doing it.

That’s just not going to end very well, even if we do get by with this. We should not want to cheat ourselves though and we need to instead find the courage within ourselves that we so badly need so we can even dare to start asking the important questions to even be able to find the path back to sensibility.

Successful investing is once again making as much money as we can safely enough, and when we refuse to do either properly, instead choosing to curl up on the floor in a helpless position, relying on prayer rather than good judgement, we’re going to end up with the level of disappointment we have chosen.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.