What is Inflation Hedge?
You ever heard in the media that Gold is inflation hedged instrument? I am sure many of us have heard this expression many times over CNBC, CNN Money etc.... So, what does Inflation Hedge mean?
In the last couple of posts, I have been mentioning that inflation is nothing more than measuring strength of the currency buying power. If currency gets weaker, we say inflation is higher since our buying power has deteriorated. So, how do we hedge ourselves against it.
It's really not that difficult and a it's very simple logic. It's just investment media make it sound so fancy and complicated such that local public get lost in financial terms. So, back to basics of Inflation - If the currency is getting weaker, people would have to pay a higher price for the same product in future as they pay for it today. So, why not hold something today that people would want to buy tomorrow such that you can collect a higher economic value in future. So, if you can own a lot of things today that people would want to buy tomorrow then you can only get richer in nominal terms in future.
Again back to economics, you have limited supply of cash inflow so you must use it wisely. Once cash is spent, you would have to wait for new cash which might take one month if you get paid monthly or who knows how your cash flow situation is. So, any asset that you think will be in demand in future can be bought with the money in hand today and you will be inflation hedged.
Also, when you buy an asset today, you need to consider following things as well:
1. Does buying the asset today has additional costs attached with it to store? In finance, we call it carrying cost. Hence, buy an asset that will have almost no storage costs.
2. You shouldn't buy an asset that may not be in demand in future because you wouldn't be able to charge more in future and hence will have negative return on your invested amount. This is called diminishing time value of money.
So, considering about principles, you wouldn't want to buy a lot of coke or pepsi bottles, or even gallon of gasoline, or anything that has a lot of storage overhead. So, what should one buy to hedge against inflation?
Some of the following assets are treated one of the best inflation hedged instruments.
1. Real Estate. (No storage is needed here)
2. Precious Metals such as Gold or Silver Bars (You can store them in the drawer, if needed)
3. Long term Futures Call Options on Oil Contracts. (Financial contracts carry counterparty credit risks)
4. DO NOT hold cash currency because that is the first one which loses value during inflation
Key note is: These instruments must stay in demand in future, else you might lose value of your invested capital. For example, if all of a sudden Gold demand dies out due to a cheaper substitutes availability in future, Gold price might fall down higher than inflation. Example holding a gold bar which lost 25% in its value due to demand evaporation while inflation was only 2%. You would lose 23% of your investment in such case.
Also, inflation hedge doesn't mean that you will always be richer in future in nominal terms than what you are today. There are many other types of risks that can eventually evaporate your wealth.
-Nitin
You ever heard in the media that Gold is inflation hedged instrument? I am sure many of us have heard this expression many times over CNBC, CNN Money etc.... So, what does Inflation Hedge mean?
In the last couple of posts, I have been mentioning that inflation is nothing more than measuring strength of the currency buying power. If currency gets weaker, we say inflation is higher since our buying power has deteriorated. So, how do we hedge ourselves against it.
It's really not that difficult and a it's very simple logic. It's just investment media make it sound so fancy and complicated such that local public get lost in financial terms. So, back to basics of Inflation - If the currency is getting weaker, people would have to pay a higher price for the same product in future as they pay for it today. So, why not hold something today that people would want to buy tomorrow such that you can collect a higher economic value in future. So, if you can own a lot of things today that people would want to buy tomorrow then you can only get richer in nominal terms in future.
Again back to economics, you have limited supply of cash inflow so you must use it wisely. Once cash is spent, you would have to wait for new cash which might take one month if you get paid monthly or who knows how your cash flow situation is. So, any asset that you think will be in demand in future can be bought with the money in hand today and you will be inflation hedged.
Also, when you buy an asset today, you need to consider following things as well:
1. Does buying the asset today has additional costs attached with it to store? In finance, we call it carrying cost. Hence, buy an asset that will have almost no storage costs.
2. You shouldn't buy an asset that may not be in demand in future because you wouldn't be able to charge more in future and hence will have negative return on your invested amount. This is called diminishing time value of money.
So, considering about principles, you wouldn't want to buy a lot of coke or pepsi bottles, or even gallon of gasoline, or anything that has a lot of storage overhead. So, what should one buy to hedge against inflation?
Some of the following assets are treated one of the best inflation hedged instruments.
1. Real Estate. (No storage is needed here)
2. Precious Metals such as Gold or Silver Bars (You can store them in the drawer, if needed)
3. Long term Futures Call Options on Oil Contracts. (Financial contracts carry counterparty credit risks)
4. DO NOT hold cash currency because that is the first one which loses value during inflation
Key note is: These instruments must stay in demand in future, else you might lose value of your invested capital. For example, if all of a sudden Gold demand dies out due to a cheaper substitutes availability in future, Gold price might fall down higher than inflation. Example holding a gold bar which lost 25% in its value due to demand evaporation while inflation was only 2%. You would lose 23% of your investment in such case.
Also, inflation hedge doesn't mean that you will always be richer in future in nominal terms than what you are today. There are many other types of risks that can eventually evaporate your wealth.
-Nitin
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