What are some good inflation hedges

This is how you protect your assets from a loss of purchasing power

Investment strategy

Many investors fear rising inflation rates. But there are no patent remedies for securing a deposit against the loss of purchasing power. Nor is it a guarantee that the portfolio will develop as hoped in an emergency. Fair value nevertheless makes a suggestion.

In any case, it is not a good solution to shift all assets into stocks, gold, real estate and other tangible assets for fear of inflation. The risk of such a portfolio would be considerable. In addition, portfolios with a relatively large proportion of bonds and short-term fixed-term deposits achieved better returns in the past, even in periods of high inflation, with lower fluctuations in value than portfolios with a real asset ratio of close to 60 percent. This is shown by calculations by the major Swiss bank Crédit Suisse.

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Short-dated bonds were the best hedge against inflation

Other analyzes also show that investors with government bonds were able to maintain their purchasing power in the past. According to this, federal bonds with a remaining term of one year have offered the best protection against inflation in the short term since 1970. Because their returns adjust the fastest to rising inflation rates. Investors usually ask for a higher interest rate when consumer prices rise. Federal bonds of all maturities have delivered an annual average return of 4 percent after deducting inflation since 1970. That is a decent result. In the early and late 1970s, when consumer prices rose at a rate of over 5 percent per year, their real returns fell to zero and 1.2 percent, respectively.

Loss of purchasing power despite monetary stability

What was valid in the past does not have to be valid in the future, as the sovereign debt crisis shows. It has turned some of the bond markets upside down. Investors have been paying the German state money since 2012 so that they were allowed to give loans to the Federal Republic. Germany pays no interest, but earns money by getting into debt - thanks to its reputation as a safe haven.

That may please the taxpayer. In contrast, such market conditions give investors a headache. As early as 2011, the yields on federal securities with a term of up to ten years had fallen below the inflation rate. The real returns were therefore negative. Those who invest in government bonds (and hold them until the end of the term) lose purchasing power, even though the inflation rate fluctuated around 2 percent in 2012, at the level that the ECB and economists consider to be stable in monetary value.

In the meantime, the situation has worsened. There is a minus sign in front of the nominal yields of most federal securities. The respective inflation rate comes on top every year. With inflation of 1.5 percent, buyers of German government bonds lose between 1.6 and 2.2 percent of their purchasing power per year, depending on the term.

Only a look back shows how it went

How big the real loss of value is, however, can always only be determined in retrospect. Because the inflation rate relates to the past. It compares the current price level with that of twelve months ago.

The yield on a bond at the time of purchase, on the other hand, indicates how high its future annual yield will be on average until maturity. This figure can also be misleading if the paper is not held until the end of the term. If it is sold beforehand, price gains or losses are possible, which lead to a higher or lower return. Investors only know in retrospect whether their return was above the rate of inflation.

A loss of purchasing power with government bonds while the monetary value is stable - that has never happened in the recent history of the Federal Republic of Germany. Nobody knows how long this trend will continue. As long as economic growth is weak and the national debt of many European countries is high, interest rates are also likely to remain low. For investors, this means: they have to bite the bullet and take higher risks if they want to protect their assets from inflation.

The inflation protection deposit proposed here is not set in stone. In contrast to the guaranteed custody account, you can vary the weighting of individual asset classes according to your risk appetite. For example, if you don't want to invest in gold, you can increase the equity component accordingly. In principle, the gold quota should not be more than 10 percent. You can increase the real estate share at the expense of the bonds. For the latter, there is a mix of different pension funds. Funds with inflation-linked bonds are also an option. However, their real returns have recently been negative.

Example of a securities account designed to protect against inflation

Daily and fixed deposits ensure stability

The daily and fixed deposit portion of 20 percent is the only fixed value in the inflation protection deposit. It brings stability, because bank deposits are not subject to any fluctuations in exchange rates. At the same time, these short-term investments are the quickest way to benefit from rising interest rates when inflation expectations rise.

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This creates a counterbalance to the longer-dated bonds, which then come under the greatest pressure. However, there are also risks - of course - with bank deposits: If inflation rises in Germany, interest rates in Germany do not necessarily have to rise. The European Central Bank, which has a monetary policy for the entire euro area, could, for example, take its time to raise key interest rates, considering the highly indebted euro countries and their weak economic growth.

The best way to divide the bank deposits between overnight money and fixed-term deposits depends on the current interest rates. Often the best overnight money conditions are on par with short-term fixed-term deposits with terms of less than one year, so that overnight money appears more attractive because of its greater flexibility. Your expectations also play an important role. If you believe that interest rates are about to rise, you should primarily rely on overnight money, which can be supplemented with one- and two-year fixed-term deposits.

The golden mean: interest rate strategies

If you have no opinion on the development of interest rates and for good reasons do not want to rely on the mostly false forecasts of others, then you should stagger your fixed-term deposits according to maturities. Such a “staircase strategy” protects you from getting caught on the wrong foot. Because if, for example, you bet on an imminent rise in interest rates with a high overnight rate and this does not happen, you will miss the higher interest rates of longer-term fixed-term deposits. If, on the other hand, you concentrate your capital on the latter and interest rates rise sharply, you will not benefit from this development because you are committed to the longer term. The stair depot is a middle ground.

Example: With an inflation protection deposit over 100,000 euros, the share of bank deposits would be 20,000 euros. Divide the amount into four equal parts. You put part of it in a call money account. You distribute the rest of time deposits with terms of 1 to 3 years.

In this way, a fixed deposit is due every year. If you invest the money again with a term of three years, this rhythm continues. You can also increase the term if a phase of rising interest rates has not yet started. Longer terms of up to five years are particularly worthwhile if the interest rate differences between the terms are large. For example, if you get 2 percent for fixed deposits with a term of four years and 2.05 percent for five years, i.e. only 0.05 percent more, the longer term does not seem particularly attractive.

However, the same bank does not always offer the best interest rates for the different terms. In the worst case scenario, you will have to split your money among three or four financial institutions if you want to get the highest interest rates (with safe banks) in each case. That can be annoying. Especially when the conditions change every week and the ranking lists with the best conditions are constantly being reformed.

If the hunt for the highest fixed-term deposit rates is too strenuous for you, you can pursue a more convenient strategy: the investor invests half of the 20,000 euros in the example in overnight money, the other half in fixed-term deposits with a three-year term or longer. With this strategy, the average interest rates are as high as with the “interest rate staircase”.

When interest rates rise, the interest rate staircase yields higher returns because investors benefit from better fixed-term deposits every year. When interest rates fall, on the other hand, the overnight money strategy is ahead. It is also more flexible because half of the money is available at all times.

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