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How to Protect Yourself From Inflation

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Hot Air BalloonOne of the unintended, though predictable, consequences of the unprecedented rescue of the United States financial system is that there will be higher than average inflation figures for years to come. While it’s been popular to dispute the reported Consumer Price Index (CPI), the reality is that the marketplace doesn’t really listen to the reported stats. It reacts to reality. Your boss doesn’t walk into your office and say “Oh, CPI says I need to give you an x% raise this year to maintain your purchasing power.” and the grocery store doesn’t increase the price of a head of cabbage a few cents every month because the BLS came out with another report.

So we need to be proactive and be aware that inflation is a real concern, before it becomes front page fodder for newspapers.

What is inflation?

Inflation is defined as a general rise of prices for goods and services. It’s why a piece of gum that cost a nickel ten years ago now costs a quarter. Why you could get comic books for a dollar but they now cost two. It’s a slow erosion of the purchasing power of a dollar and it’s generally accepted that a low steady rate of inflation is good for an economy. The reason why inflation is a predictable consequence of the rescue is because the Treasury and the Federal Reserve introduced a lot of money into the system.

At the most basic level, imagine if you and your friends had the only grocery store in the universe all to yourselves. The owner of the store only had you as customers. The price of the products in that store depends on how much money you had, since the owner had to sell to you, he or she couldn’t hold out for other customers. There is no reason you keep any money to yourself because it’s the only grocery store available. If you all had a combined $100, then all the goods in the store had a value of $100. Now imagine if I just handed you $100. The goods didn’t change but now the total value is $200 because that’s what you have in your pocket. Each dollar is worth less because there are more dollars. (inflation is a little more complicated than that but I think you get the idea)

So why hasn’t inflation already happened? Well, partly it has to do with the demand. With millions out of work and with consumers saving more, you have fewer people going to the stores. So the pool of spenders has gone down even though the supply of dollars has gone up. Also, there’s been a tremendous amount of wealth destruction in the form of failed mortgages and lost investments. So while the printing presses seem to be going crazy, there’s a bonfire going on at the same time. It remains to be seen what sort of financial wizardry will be used to try to keep inflation in check but it still pays for us to try to mitigate the risk ourselves.

However, just because it’s not here yet doesn’t mean it won’t ever come… so how do we protect ourselves from inflation?

Buy a House

If you were to look at your budget, housing is likely one of the largest line items. If you’re a renter, and you’re in rent controlled housing, inflation will slowly increase how much you pay each year. By buying a house, you lock in a monthly payment that will only increase if (when) insurance and real estate taxes increase. You won’t have to pay more simply because inflation has sucked away some of your purchasing power. In fact, the higher inflation is, the cheaper your housing becomes because the dollar amount remains the same for the life of your loan.

The risk is that your house loses value, which is a risk of any investment, but in this case we are more concerned about inflation eroding our purchasing power. Since we are still getting the same product, housing, at the same price, it is less important how inflation affects our other dollars in this category.

Gold

The reason why gold became such a hot investment the last few years is because it’s a store of value. I think a lot of people approach gold as an investment, which is a mistake. You should think of gold more like a lockbox and less like a stock. The reason why gold is considered safe has to do with how if the United States government collapsed and the dollar became worthless, you could bring your gold to another country and exchange it for their currency. The USD would be worthless but your gold would still have some value. That’s the most doomsday of scenarios but it’s an example of why gold became popular.

So why does gold offer protection against inflation? It’s because you get to take some of your dollars and put it outside the US financial system. The problem with gold is that it also has a speculative component and is seen as a hedge against crisis (like the doomsday scenario I mentioned earlier) so you’re “paying” for that whenever you buy gold. Buying Coca Cola is probably a good investment because it’s a good company but you can take a good investment and make it a terrible one by buying at the wrong price. Unfortunately, gold is getting a lot of press now so chances are it’s not a great price.

Inflation-linked Bonds

Series I bonds and Treasury Inflation Protected Security are frequently touted as great places to put your money to protect it against inflation. They are not perfect but they are good enough and the principal is protected by the full faith and credit of the United States Government, unlike the value of your home.

What you get for that safety is an asset that keeps pace with inflation but won’t knock your socks off. While your home can appreciate in value faster than inflation, these Treasury bonds won’t offer much more than a chance at keeping up with inflation. You don’t get rewarded unless you take some risk and since these bonds are one of the safest, you won’t be rewarded that much.

Summary

There are no “perfect” ways to protect yourself from inflation but the three I’ve mentioned seem to be the three best ways that I’ve found. My approach to this problem was I could do one of two things – I can either lock in your expenses (housing) or you can lock in the value of your money (storing it in gold or inflation linked bonds). Beyond that, I’m not sure there are any other approaches out there.

If you have a good idea at how to combat inflation, I’d love to hear it. I’m a novice in these sorts of things so I hope to learn from you all too!

(Photo: ronnie44052)

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38 Responses to “How to Protect Yourself From Inflation”

  1. Ron says:

    I like the idea of buying real estate and solid, well run companies as a hedge against inflation. Gold not so much.

    The problem I see with “gold as a store of value” is that it gets inflated just like everything else. It’s subject to emotional ups and downs like everything else. If it tracked along perfectly with inflation, then yes, but ii doesn’t. Gold very well could be in its own bubble right now, like real estate, technology stocks in the late 90′s or tulip bulbs in the 1600′s.

    Too many people buy gold because it’s the hot product of the moment and the financial press crows about how high its price has risen.

    The chances of the ultimate gold doomsday scenario happening are slim to none and besides, where ya gonna keep all that gold? In your homes? At some repository 5,000 miles away? If the whole world does collapse, do you really think that repository will send it to you?

    • Steven says:

      Gold is useless in a doomsday scenario. If the US collapsed, we’re taking the rest of the world with us. Look at the most recent stock market crash, the whole world felt it. In this global economy, every action has global consequences.

      Housing can go either way. Like you said, the mortgage locks in costs for the owner, so their costs aren’t going to spiral upwards. And you are correct that inflation would make costs go up and raise rents. But the thing people forget is that there are always two components to renting: buying and selling. The owner is selling the use of the apartment, and the renter is buying the use of the apartment. If the price isn’t right, then people won’t sign. People seem to think that they can just set rent at whatever they want and renters will line up at the door. This also translates to people selling their homes for what they think they’re worth.

      If some poor shmuck is willing to pay for it, go ahead. I’ll keep looking.

      • Jim says:

        With respect to rent, the idea is that inflation would make everything more expensive, not just one unit. So if all the apartments available for rent all went up 5%, you have no choice but to rent for 5% more because no rentable places exist otherwise. Of course, there are always exceptions in real life like people in special scenarios and whatnot, but the idea is still the same.

    • Jim says:

      That’s the risk of gold and the stock market, that there is a “store of value” component and a “speculation” component.

  2. CK says:

    you could also borrow gobs of money at today’s low rates.

  3. One more idea (albeit somewhat specific):

    Buy functioning crop-producing land, e.g. a farm or a forest. The value of your crops – consumable commodities – will grow with inflation, e.g. wheat or wood.

    Further, the land value is tied to the value of the crops produced which will rise with inflation.

    But what if you aren’t a farmer? Well buy the land and lease it to a farmer. Or buy forest land – all you have to do there is hire a team of lumber-jacks every decade or so to harvest & clean up the forest.

    My folks are seriously considering the forest land route – they already own a bunch and are thinking of expanding.

    • Jim says:

      A clever idea if you can get a few people together to do it. What’s nice about bonds or gold is that you can get in with very little, unlike a house or a crop producing land. A house has other benefits as well, like you can live in it, whereas crop producing land offers benefits that don’t necessarily line up with your needs.

      Clever idea though.

      • saladdin says:

        Raw land loans are normally higher rates then loans for a house. I would be very surprised if inflation would keep up with a raw land loan of say 6, 7 or 8%.

        saladdin

        • Raw land is often dirt cheap also. You could get a meaningful plot of land for not much money – no need to get leverage via debt.

          E.g. in my folks area you can buy forest for about $500 / acre. Fields suitable for corn etc go for about $1,500 per acre.

          • dmeanea says:

            “Raw land is often dirt cheap”

            clever :)

          • saladdin says:

            I live in a rural area of the Great State Of Tennessee. Most land is family owned in large 100 acre lots. No way would 500 get an acre here. First, no one splits lots. It’s all or nothing so you can’t just buy 1 acre. And no way you would throw 3-5k (going rates) an acre for a 100 acre lot.

            I really don’t think the average bear understands how little 1 acre is and how much raw land you need to grow crops or timber for resell.

            saladdin

  4. Jessica says:

    I am a big fan of I bonds. We started buying them 2 years ago as a form of college savings for our future children. Since we are starting waaaaay ahead, we aren’t looking for stock market performance out of them, just slow and steady wins the race. Plus, I have to say that it doesn’t hurt my feelings to log in and see that the current earnings rates are between 3.41% and 3.77% on them when other safe investments (CDs and savings accts) are earning 1.5% at best.

    • J's Mom says:

      Should one wait, then, until rates are higher before buying bonds, then? Its seems to me that this and gold pose the same problem- if you haven’t gotten into it yet, you’re late! I fully intend to go for I Bonds as soon as the rates improve.

      • Edwin says:

        When comparing bonds to gold the difference is that the bonds will constantly pay out that rate until maturity whereas gold will decrease in value if it’s in a bubble. So if bond returns are low, they are still a constant.

      • Jessica says:

        I don’t try to time anything in that sort of way. We started buying I bonds because we wanted to start a college savings fund and this was the option we liked the best. The interest is tax free if used for education, they are in our name and not our kids (because we don’t have any yet) and we won’t lose principle or value since they are tied to inflation. If rates go up, that’s great, if they go down, that’s fine too. If our kids don’t need the bonds for college then I will consider our portfolio diversified since we’re young and the majority of our retirement savings are in stocks.

        One thing to keep in mind is that the I bond rates change every 6 months and are not constant. There are two components, one set at the time of purchase of the bond that is always the same (base rate) and one that adjusts every 6 months (tied to the inflation index) that are input into a formula to give you your earning percentage. The very same bonds earning 3.41% today were earning near 0% 6 months ago. Jim’s post about I bonds is pretty informative about the subject.

        • JT says:

          The problem I see with using I-bonds for college savings is the interest on I-bonds is based on CPI, and college costs historically have risen faster than the CPI. College costs rise on average around 8% or so a year, whereas the CPI has historically risen closer to 3% a year. So even though I-bonds may do a better job of keeping up with inflation than some other bonds, you’re still losing buying power every year.

  5. Nick says:

    I strongly question your recommendation of gold. The recent skyrocketing of gold prices (despite DEFLATION in the economy) has shown that it is extremely prone to speculation, and not a good place for “safe money”.

  6. RJ Weiss says:

    Agreed w/ Nick.

    If you look at gold prices for the last 30-40 years, it has underperformed inflation.

    TIPS are a lot easier way to protect yourself from inflation.

  7. jsbrendog says:

    gold was huge in my office among the traders about a year ago. One guy had a “gold guy” he bought from and sent everyone else there. It was like a craze in the office.

  8. dmeanea says:

    Jim, it seems to me there’s another inflation analogy to be found in the Bargaineering Bucks system. Back before you gave a buck for daily logins and for every comment submitted, the auction items were going for less than half of what they do now. The flood of BBucks injected into the system has greatly increased competition for the scarce resource (auction items).

    • dmeanea says:

      I feel like I have to keep making comments just to keep up with BB inflation! :)

    • Jim says:

      That’s a good point, however the buck for every comment submitted has been in existence since I started the program. The bucks for daily logins has been more recent but I think the problem has less to do with inflation and more to do with demand for the stuff listed. Prices went up considerably the last time I blogged about the program and have stayed roughly around the same.

      Still, excellent observation. :)

      • saladdin says:

        Guilty.

        BB’s are nice but they are worthless unless converted into an ING referral. It didn’t matter to me if it took 6 BB’s or 60 to get a referral.

        saladdin

  9. Edwin says:

    I think the best hedge for inflation is a balanced portfolio with TIPS and bonds. I definitely think that gold is in a bubble right now and even beyond that it was actually a worse hedge for inflation when currencies were backed by it than our current fiat system.

    Housing is a difficult recommendation because you have to deal with tax and other expenses as well as paying for the loan itself. Yes it’s a steady expense, but I would rather have the money in bonds which give you a steady payment over their life. Of course if you already have a house that’s great, but getting into one with inflation at the top of your list of reasons is silly.

  10. Nien Chang says:

    What about stocks in companies that book revenue in non-US dollar denominations? This could be a good hedge in case inflation really strikes here in the US. There are plenty of foreign companies that trade on US-based exchanges

  11. I agree on most points that this article makes. I might lump some other commodaties in there as well, like oil.

    A lot of people do not really understand the concept of inflation. Typically it is figured that inflation runs 3% annually, although lately it probably has not been that high. One of the best ways to gauge it unofficially is to watch the price of things you routinely buy.

  12. thomas says:

    Look at disaster areas like NOLA, Haiti, and Chile. Inflation, gold, and cash mean nothing if you don’t have a gun, water, and food.

    Don’t forget to protect yourself from a natural disaster, not just an economic.

  13. eric says:

    I like I-bonds and TIPS the best.

  14. aua868s says:

    I haven’t tried I-Bonds yet…with the way economy is, it should be worth the try.

  15. Crawdad says:

    Has anyone tried “laddering CD’s”. Check it out. I laddered a 1yr, 2yr, 3yr bump rate, 4yr and 5yr CD. In 5 years I will have a 5yr CD maturing every year. Within 5 years hopefully the rates will be much more than 3.5%.
    Comments please.

  16. Shirley says:

    I did this by creating six 12 month CDs, one every other month. As each comes due, I roll it over if the rate % is good. So far I have been happy with this system, although it is not actually “laddering”.

  17. C. Williams says:

    The really only true way to stifle inflation is to not spend. Because the Fed and the Government have opened up the dam of the printing press it has inevitably put us all in a vacarious situation. If the economy starts picking up again and we start to see growth ie; spending then the inflation monster will raise its ugly head and everyone will be hurt except the Goverment because they were able to use the money 1st, prior to inflation. The devaluation of the dollar will in a sense tranfer wealth to the Fed because the initial lets say for a simple explanation, 100 dollars of printed money davalued by inflation of say 10% which is a realistic percentage, then 100 dollars will be worth 90 dollars leaving a 10% reduction in outlay caused by inflation. Therfore the Goverment pay 10% less when the bill comes due. However, consider a generation of this as we have seen and the value of the Goverments spending is reduced by half. We the people pay that difference in purchasing power.


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