Risk Factors in the Market
Inflation, what is the first thing that comes to your mind? Higher prices, money losing its value, less buying power. The definition of inflation is “the decline of purchasing power of a given currency over time”. The US Federal Reserve considers inflation to be healthy as long as it is in check, targeting about 2% annually. This is actually one of the main mandates of the Fed, maintaining stable prices. What happens though when inflation gets out of control and how bad can it get? We’ll use Venezuela as an example.
1970 Venezuela was one of the top 20 richest countries in the world, propped up by its oil supply. In the early 1980s it was certified by the World Bank as an “Upper-Middle Economy” and democracy was flourishing. Then later that decade and in the 1990s problems started to arise, the economy was slowing and government overspending continued. In 1992, the country was in political trouble and had a coup attempt to throw out the current leader, led by Hugo Chavez.
Chavez eventually ascended to the presidency where he promised to rewrite the constitution and give the people more social programs. Spending continued, oil continued to be the country’s backbone, inflation continued to creep upwards slowly. In 2005 it cost 450 Venezuelan Bolivars to purchase a dozen eggs as citizens started to feel the effect of that inflation. In 2015 oil prices fell sharply and that along with a lack of reinvestment in the nationalized oil industry, the country became one of the poorest in the world. That dozen eggs that cost 450 Bolivars 10 years beforehand now costs 773 billion Bolivars. The wages did not grow at that same rate, a civil servant with a doctorate and 20 years of service, earned monthly enough to buy only 10 dozen eggs.
This is the horror story of rampant inflation, an extreme example, but one in our time. So how do you protect against this?
As inflation goes up the price of goods typically goes up proportionately. This means if you hold cash, you keep losing value as goods cost more every day. If you were to own the goods, however, you are on the flip side of this equation and can charge more each day inflation goes up. So what are some ways to be on the “goods” side of the equation and not the “cash” side?
Stocks. My first line of defense against inflation, when you own stocks you own a piece of that company. Regardless of what the dollar does you still own a certain percentage of that company, and that company is probably still selling their goods and turning a profit doing so. What this means is that there is still value in that company no matter how we denominate it. Keep this in mind and don’t let your statements convince you that this is a pile of money in an account, it’s property that you own, not cash. Stocks can be rocky at times so it is important to remember that these are a long-term solution, if you are going to panic and run when prices go down then these are not for you. The reason these are my first line of defense though is that they will continue to work for you after the inflation storm has passed, being like I said before, a good long-term solution.
Land and Real Estate. These are another good defensive strategy that can turn long-term results for you too. Many of the same principles apply as above with a couple of extra caveats. This kind of investment is not as readily bought and sold as stocks which can be kind of a double-edged sword. On the positive side, it’s less likely to have large price swings due to emotions and knee-jerk reactions such as stocks, but on the downside, it can mean being stuck holding on to something while waiting months or even years for a buyer.
Treasury Inflation-Protected Securities (TIPS). Our first shorter-term solution to the inflation problem. TIPS are available from the US Treasury in 5, 10, and 30 year maturities. These notes pay interest every 6 months, and the principal value is tied to the Consumer Price Index or CPI (one of the most commonly used measures of inflation in the US). This means that as the principal value increases with inflation so does the amount you are being paid interest on, but on the flip side in a deflationary environment it means that the principal amount can go down with the CPI as well. If you do not want to hold the securities until maturity they are tradeable on the open market as well. The risk with these is that if interest rates go up they will still be negatively impacted like traditional bonds.
Commodities. Oil, gold, and base metals are the three most commonly traded. These are all traditionally inflation-protected securities as their price tends to rise along with inflation. Trading these can be difficult as many factors can affect the pricing, ranging from localized issues with mining or supply chains, all the way to broad geopolitical issues such as sanctions or trade embargoes. Due to all of the pricing factors out there for commodities, they tend to be much more volatile than stocks, so they are not for the weary investor or someone with a shorter time horizon.
Crypto-Currency. The newest player to the game here, these are still highly speculative and are not recommended to be a large holding. Crypto-Currencies can be a good hedge against inflation since they can be used as an alternative to the dollars as an exchange for goods. However, the downside is that there are many players in this game currently and likely will not be in the future, meaning some cryptos will fail and people will lose whatever they have invested in them. Another downside factor is in the regulatory risk currently faced by crypto-currencies, there has been a lot of talk at the national level on how to regulate these without a lot of clarity on what that would look like. Hopefully, there will be some light shed on what that regulation is in the next year or so. Until then the unknown is always a risk and we do not know how investors will react to any new regulations, creating extra volatility in an already speculative market.
If you want help seeing how inflation could impact you financially then reach out to Joe or Nathan at Eighth Wonder Investments to schedule a comprehensive consultation today! We take a holistic approach to finances and together we can come up with a plan to reach your goals.