Kassandra Learn: What is Inflation? (Part 2)

In a nutshell…

We’ve looked at what inflation is, some of the causes for inflation, and the consequences of the “silent thief” on our savings and income. Now we’ll look at some of the strategies and investments people use to protect (or “hedge”) against inflation, including precious metals, real estate, and crypto currency.

How to Hedge Against Inflation

We’ve seen that many politicians and banking authorities consider inflation the “price of doing business” because it motivates people the spend instead of save. While this may increase demand, it also means that keeping your savings in fiat currency is not a very good idea since cash necessarily loses it value and purchasing power as a part of a pro-inflation economic system.

What can we do to make sure our savings compete and even beat the rate of inflation? We need to find an asset that, unlike fiat currency, holds its value even when inflation bites. These “stores of value” work best when they are “hard assets”, meaning that they are:

  • scarce (there is a limited supply of them)
  • durable (there is an increase in demand and therefore value over time)
  • accessible (people can buy and trade, and something something they see as valuable)

These are assets like stocks and government bonds, precious metals, real estate, bitcoin and crypto. Even handbags, wine, and whiskey are being more and more often these days added to diversify investor’s portfolios. Basically, anything that’s seen as getting better over time can be used as a hedge. But not all hedges are made equal, as we will soon see.

Different Hedges Against Inflation

Before we continue, one things we need to understand is that when it comes to deciding on the “best” hedge, there are different benefits to each option and the amount of time you can afford to keep your money locked into a certain asset.

We’re going to look at just three inflationary hedges today, rather than examining complex securities and investments that are typically less available to the unbanked or ordinary people. We’ll return to this topic in the future though to examine how to put together a diverse investment portfolio of assets that can reduce risk, and beat inflation.

Essentially, what you need to remember is:

  1. No single method will work best, all inflation hedges have their own advantages and disadvantages.
  2. “Don’t keep all your eggs in one basket!” Spreading investments across a number of different sources with various levels of risk is much more likely to offer steady returns than one big bet.

Gold

There are many precious metals that people choose to invest in but we’ll look at an old classic, gold. This is the metal we hear the most about when people talk about an inflation-busting commodity so it is regularly touted as a good hedge.

As for the advantages, gold is tangible. It has definite dimensions and (in small enough quantities) can be transported relatively easily. There’s always a psychological comfort in being able to see and hold your investment if you choose to physically buy it. Speaking of holding, gold is considered better at holding value compared with fiat currencies like the U.S. dollar or the Euro which, as we discussed, lose purchasing power in times of high inflation.

However, when looking at the value of gold, the price can be very variable in the short term: these ups and downs only smooth out to a consistent increase when looking at appreciation in value in the longer term. So how long? We’re talking decades or even centuries.

Furthermore, gold might be seen as a good investment for big business but less useful for ordinary investors. Buying bars of gold isn’t very practical, and leaves you open to theft or risk, so people instead invest in gold indirectly via metal trading markets. Unfortunately, like many commodities the value of gold is highly influenced by current events and external developments, as well as hoarding and speculation by professional traders. There are also more barriers to entry such as fees and commission if you wanted to do more than just sit on those gold bars and actually sell and trade them to unlock their value.

So if you don’t have a century to wait for your investment to catch up with a sudden spike in inflation, what are your options?

Real Estate

Property is another classic hedge against inflation. Like gold, it’s tangible (you can touch it, use it, it serves a physical purpose, etc.) and so seems more likely to hold value when inflationary pressures affect fiat currency.

In fact, since prices rise overall during periods of inflation, property values also go up. Rents also increase which means that properties have a higher income from rent that increases over time, more than keeping pace with inflation.

Furthermore, as a currency loses its value, the value of any debt owed also decreases. This is “depreciating debt” and here’s how it works. If you take out a mortgage, you may be set a fixed amount to pay back over a long period. However, while this amount stays the same, the value of the currency slowly drops due to inflation so if you’re smart and able to rent a place out to someone, you’ll be making more and more money but the repayments remain the same.

However, while real estate may seem like an ideal option, it just isn’t realistic for many people. After the 2008 market crisis, in part caused by easy access to housing loans and mortgages that could never be repaid, many people struggle to get the savings together to buy one property for them and their family, let alone multiple properties that they can rent out.

Plus, many mortgages are dependent on a stable income. In a financial crisis, when incomes don’t increase and even fall, it’s all too easy to fall behind on mortgage repayments even with the benefit of “depreciating debt”. Then your investment literally becomes someone else’s property because it was never fully yours to begin with.

Finally, there’s upkeep and actually finding tenants if you want to make money renting a property out. This isn’t sustainable on a large scale. In a fantasy scenario where everyone held multiple properties as a hedge, then no-one would need to rent and the housing market would collapse.

Bitcoin

So what about crypto? Similar to how gold is just one of many precious metals, there are countless crypto coins and tokens but we’ll choose trusty Bitcoin as our example because it has some special properties that set it apart.

Namely (as the U.S. Securities Exchange Commission recently confirmed), Bitcoin is uniquely classed as a commodity and not a financial product and this doesn’t look likely to change any time soon. What does this mean? Essentially, BTC isn’t subject to as much regulatory interference as stocks, bonds, or securities.

This makes Bitcoin a perfect comparison point with other commodity hedges like precious metals. And while it may be much newer than traditional hedges such as real estate, Bitcoin definitely passes those “store of value” tests we mentioned earlier.

  1. There is a limited supply of Bitcoin that can be mined, capped at 21 million BTC. This makes Bitcoin scarce.
  2. For that reason, Bitcoin is also seen as durable: the same Bitcoin cannot be duplicated, sold twice, or faked. These anxieties were the main obstacles to a widely accepted digital currency before Bitcoin changed the game.
  3. Finally, Bitcoin has the potential to be even more accessible than fiat currency because it has an agreed value and can be exchanged freely without the intervention of banks or governments.

Bitcoin is divisible

Another advantage is that, unlike a bar of gold or a house, it’s much easier to subdivide a Bitcoin to unlock its value immediately. You can’t exactly saw off a room or cut off a slice of gold if you wanted to! And you’d have to subdivide a property or land and sell it off piece by piece to unlock its value. Likewise, gold would need to be traded for smaller pieces or even melted down and separated unless you wanted to trade it for fiat. All of this takes time, whereas Bitcoin can be traded almost instantly by comparison.

Bitcoin is fungible

Bitcoin is also more fungible than the other assets we’ve mentioned: one Bitcoin holds the same value as another, they’re identical in terms of price.

Land and property are not fungible. Not all land was made equal. One square foot in one place isn’t worth the same as a square foot somewhere else. Location, purpose, development, resources; all of these factors determine the worth of a piece of land.

Plus, real estate can be an extremely volatile market, especially during a property bubble. Consider this: before the Japanese property bubble of the 1980’s burst, the Imperial Palaces in Tokyo were worth more than the entire state of California. Obviously, an investment like that is unsustainable, and the markets quickly corrected themselves with devastating consequences for ordinary people.

Bitcoin is hardy

So are there any downsides to Bitcoin as a hedge? It was only made available for trade in 2009 so it doesn’t have the same historical data as precious metals and real estate. Despite this, BTC has weathered previous downturns quicker than metals or property.

Bitcoin’s variable value is also seen as a negative, making its value seem too unpredictable. However, BTC is much like any investment: volatility is always much more of a problem when you choose to invest in a single asset. Gold prices, for example, have been subject to massive changes in value over the last few decades: hitting a peak in 1980 that they have never returned to.

So what’s the best hedge? Diversity!

Like we said before, the smart saver makes sure to not put all their eggs in one basket. To protect their “hedge” from changes in value but still keep it competitive with rates of inflation, investors tend to put their money in several different products. This includes the hard assets we mentioned, with crypto (and Bitcoin specifically) becoming more and more popular as a way of diversifying investments, especially among the ultra-rich.

Join us in future articles where we’ll explore other investment options, and use Kassandra to find ways to make your money work harder for you so that when inflation bites, you’ve got a plan.

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