10 Ways Investors Can Protect Themselves Against Inflation

After staying below 3% since 2012, inflation leapt up above 5% earlier this year. Although the most recent reading in August showed a tiny slowdown, consumer prices are rising fast enough to make many investors nervous.

Inflation is an investor's adversary because it offsets investment growth. Say your portfolio grows 10% over 12 months. If inflation in that time is 5.25%, it pulls down the net growth of your purchasing power from 10% to 4.75%. With weaker investment growth, a high inflation rate could even swing your net returns into negative territory.

You can't eliminate the effects of inflation, but you can take steps to manage them. Here are 10 strategies to consider.

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TIPS are inflation-indexed U.S. Treasury securities. The principal value of TIPS rises along with inflation, as measured by the Consumer Price Index, or CPI. When the bond's principal value goes up, so does the bond's interest payment. That gives you a nice income boost in the short term, plus a higher return of principal long term if inflation remains elevated.

Note that TIPS can lose value in deflationary periods, but the value never drops below the original principal invested.

You can buy TIPS directly from the government via TreasuryDirect. Or, if you are willing to pay fees in exchange for convenience, you could invest in a TIPS exchange-traded fund (ETF) or mutual fund. Funds have the advantage of providing exposure to various maturities in one position.

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Long term, stocks historically have outpaced inflation by about 7% annually. That behavior could justify higher exposure to equities as an inflation hedge.

There are caveats to this strategy, however. Increasing your equity exposure is a long-term strategy. In the short term, the cushion equities provide against inflation may not be what you want. Inflation is bad for business, just as it's bad for your household finances. As prices rise, businesses will pay more for debt, materials, and labor. That can limit business profits, as well as stock price growth.

Another trade-off of owning more stock is increased volatility. That may not be an issue if you are young and saving for retirement. But you likely don't want more volatility if you are older than 55 -- unless you have a sizable, guaranteed pension or other income source separate from your portfolio.

If you do want to increase your equity exposure, a greater share of dividend-paying stocks is an approach to consider. Lean toward stocks with a long history of increasing shareholder dividends regularly.

Companies like 3M, IBM, and Kimberly-Clark have raised their dividends annually for decades on the strength of reliable and growing cash flows. Once a company earns its reputation as a generous and consistent dividend payer, the leadership team is usually motivated to keep the streak going.

A rising dividend is a nice thing to have when prices are trending up. If you're retired, you can use the extra cash to pay your bills. Or if you're still building wealth for retirement, you can reinvest your dividends to expedite your portfolio's growth.

Commodities can be an effective inflation hedge. One Vanguard study concludes that with a 1% rise in inflation, commodities could jump 7% to 9%.

Commodities are raw materials and natural resources like oil, agricultural crops, precious metals, and livestock. You can invest in commodities directly via futures contracts, but that's only advisable if you are an experienced trader. Otherwise, a commodities ETF is probably a better fit. To keep things simple, look to funds that hold stocks of companies that benefit from rising commodity prices -- as opposed to ETFs that hold commodity futures.

As you research your commodity fund options, you'll see they don't perform as consistently as, say, an S&P 500 fund. This is the nature of specialty positions -- they perform well in specific situations and not so well the rest of the time. For this reason, keep your commodity exposure low to start, until you're comfortable with how it behaves within your portfolio.

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Investing in physical real estate can be a good inflation strategy, because property values and rents rise with inflation. The challenge you might face in this current environment, however, is that property values and rents are already elevated. If inflation cools off, the value of your asset might do the same. That would be a tough pill to swallow since real property is both expensive and illiquid.

Alternatively, you could invest in a real estate ETF like Vanguard Real Estate ETF. The cash outlay required would be less than owning physical property, and you can sell your position quickly if you need to. The ETF invests in real estate investment trusts, or REITs, in various sectors, including healthcare, hospitality, residential, retail, and industrial.

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Gold may be one of the most talked about inflation strategies, since many investors swear by it as a reliable store of value. But you should know that gold's historic performance in inflationary periods has been inconsistent. In the 1970s, it did very well. Unfortunately, the precious metal's returns have been negative in other high-inflation eras, including the early and late '80s.

Gold shines brightest in volatile bear markets. According to Morningstar data, it has outperformed when the stock market has recorded deep losses. An extended period of high inflation could lead into a rough go for equities -- which may justify adding a small gold position to your portfolio.

Look to invest in a gold ETF. That will be more convenient than hiding gold bars under your bed.

An annuity is a stream of guaranteed income payments you buy from an insurance company. The payments can be structured to last the rest of your life, which makes annuities a suitable source of retirement income. The rate of return is less than what you could earn in the stock market, but the risk is lower, too.

You can add inflation protection to an annuity, so that your income payments will rise (or fall) with CPI changes. The trade-off is that an inflation-indexed annuity will be more expensive than an annuity with no inflation protection. If you don't want to spend more, your inflation-indexed annuity will have lower starting payments versus an annuity that's not indexed to inflation.

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Short-term, investment-grade bonds can be a relatively safe inflation shelter. If higher inflation causes interest rates to rise, short-term debts adjust quickly -- upon maturity, they get repriced to market interest rates. Long-term bonds don't have the same flexibility. Bonds that are stuck with low rates from a pre-inflation era will be less attractive to investors. Their market value could erode as a result.

An ETF is the simplest way to invest in a diversified bond portfolio. You'll see higher yields and higher risk in corporate bond ETFs versus government bond ETFs. You may find the right balance of risk and reward in an ETF that combines corporate and government debt into one portfolio, such as the Vanguard Short-Term Bond ETF.

In some situations, taking out a fixed-rate mortgage could be a smart move ahead of rising inflation. The idea would be to lock in a 30-year loan at a low rate now, before inflation pushes interest rates higher. You'd use the debt to fund a home purchase or, if you're refinancing, to pay for home improvements. Either way, the value of your property should appreciate as inflation rises.

Of course, taking on a 30-year debt is a huge commitment. To start, you'd need the capacity to make the payments. You'd also want to consider how you'd feel about the debt obligation if inflation quiets down.

Bitcoin investors say the cryptocurrency is immune to inflation. The rationale is that it has a limited supply, so it cannot be overdistributed and devalued the way paper money can.

In reality, Bitcoin hasn't been around long enough to have proven itself as a reliable inflation hedge. During the 2021 inflation surge, the cryptocurrency showed mixed results. It rose sharply in the first quarter, dipped in June, and then recovered partially in August. That doesn't paint a clear picture with respect to inflation.

Still, Bitcoin may prove more reliable in the long term as it matures. If you'd like to add it for diversification purposes, do so in small doses -- and be prepared for a wild ride.

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If you're worried about inflation, invest in assets that become more valuable as prices rise. Just recognize there's a timing element to that strategy, which increases your risk. If inflation cools off, for example, you may regret a decision to double down on commodities or TIPS.

You can manage timing risk to some extent by taking a long-term view of any investment decision you make. In other words, proceed with portfolio adjustments that you're comfortable with for the foreseeable future. But be cautious about decisions that only make sense in the moment that inflation is on the rise.

Catherine Brock has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Bitcoin and Vanguard REIT ETF. The Motley Fool recommends 3M. The Motley Fool has a disclosure policy.