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Why Do Investors Hedge Against Inflation?

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In 2022, the Guardian reported that U.S. inflation rates had reached a 40-year high. And between rising interest rates and skyrocketing grocery bills, the effects of inflation are becoming increasingly difficult for people to ignore.

As an investor, you've likely been watching the economy with some concern. How can you protect your assets and maintain a thriving portfolio in these market conditions?

The good news is that there's a time-tested investment strategy that all the big banks and major financial players use:

You can hedge against inflation with commodities.

Read on to find out how you can execute this strategy today.

Why Do Investors Hedge Against Inflation?

In investing circles, they say that "Time in the market often trumps timing the market.". If you're buying companies you believe in and you're expecting prices to keep trending up, does hedging even make sense as a strategy?

Here are a few reasons why hedging is a valuable tool to have in your investing arsenal.

1. Hedging Can Protect Investors From Market Fluctuations

Even when you feel confident in your investment choices, no one's portfolio trends in a straight upward line. During downturns and market corrections, hedging can help you reduce your losses.

How? Because you're purchasing an asset or taking a position that's expected to go up as the value of your other stocks goes down.

Let's look at an example.

Imagine you're heavily invested in the tech sector. While your portfolio has been completely outperforming the market overall, you've noticed that the tech sector is taking a beating. And at the same time, you know that utilities tend to do well when technology stocks are struggling.

Now you have two options.

You can sit back and take the huge hit as the market corrects itself. Or you can invest a small portion of your portfolio into utilities and experience reduced losses or small amounts of growth.

As you get closer to retirement, your portfolio should be more stable and lower risk. Hedging is a risk management strategy that allows you to protect your funds in difficult or adverse market conditions.

2. Hedging Can Let You Lock In Your Profits

At first glance, this might sound a bit counterintuitive. But there's something investors need to understand when it comes to hedging:

Sometimes transactions aren't about making as much money as possible. There are times when traders and investors will take positions with the goal of not losing money.

Let's say that you're a farmer. In order to keep your operation running, you need to sell your crops for at least $11.50 a unit. Knowing your fixed costs, would you rather see what the market is offering after harvest season or would you rather take out a futures contract that allows you to sell your wheat for $12 a unit before the growing season has even begun?

In this scenario, you do lose out on potential profits. If there's a hurricane in another state that bumps prices up to $15 a unit, you've lost out on a potential windfall.

But if you're hedging to keep the lights on in the farmhouse, maximizing your profit isn't the point. Hedging in this scenario makes it possible for you to lock in the money you need.

While you might not directly own the means of production like a farmer would, hedging can be used to ensure that your portfolio remains profitable.

3. Hedging Promotes Certainty

The financial crisis dominated the headlines in 2008. But what a lot of people don't realize is that many airlines were struggling to make money in 2007 and 2008.

What was the reason for this struggle? Skyrocketing fuel prices.

With a hedging strategy in place, however, these airlines could have kept themselves in the black.

Here's how:

Remember what we just said about how farmers can guarantee themselves a profit by purchasing a futures contract? The locked-in price mechanism can be equally as effective for businesses that depend on certain goods.

In many industries, margins depend on securing raw materials at the best prices possible. If airline companies had hedged on oil going into 2008, the industry's crisis might have been averted.

This is one way that businesses can manage their costs. Individual investors can get the same results for their purchasing commodities.

Making Sense of the Commodities Market

Strictly speaking, economists describe commodities as goods that are seen the same way by the market regardless of who has produced them. Or to put it another way, commodities are assets that are affected by supply and demand as opposed to investor sentiment.

To be clear, this isn't the same as substituting one brand for another. The goods that are considered commodities are typically raw materials.

Commodities fall under two general categories: hard and soft.

It's easier to think of soft commodities as goods that can come from farms. These would include plant-based crops or livestock.

Meanwhile, hard commodities, like precious metals and natural gas, are often mined or drilled.

The reason why investors often counter rising inflation with commodities is simple:

When general prices rise and the stock market is in turmoil, commodities don't just survive — they often thrive.

The Two Main Benefits of Hedging With Precious Metals

We've just talked about the benefits of hedging. And then we've covered commodities as a vehicle for hedging. Why would you invest in precious metals specifically?

By our count, there are at least two really good reasons to choose precious metals over other types of commodities.

1. Precious Metals Have a Proven Track Record

According to research, gold has been in use since around 4,000 BCE. Ancient civilizations used precious metals as money and then as jewelry. Today, investors tend to use it as a value store.

If there's anything that the last several thousand years have taught us about precious metals, it's that they are practically bulletproof as a value store. This verifiable history is a big part of what makes gold and the precious metals market so popular during times of economic uncertainty and rising inflation.

This brings us to our next point ...

2. Investors and Laypeople Believe In It

Remember the Dotcom bubble? When the money is flowing, everyone wants to speculate. But when times get tough, investors tend to purchase gold and people are often more willing to buy gold bars and precious metals.

Why? Because they know that precious metals will stay valuable in a pinch. And because this belief still exists, precious metals investors can be confident in their financial decisions.

Of course, market fluctuations and investor sentiment can have an impact on short-term gold volatility. But because society understands the value of gold, you can use it as a long-term hedge without having to constantly readjust your portfolio.

Your Precious Metal Investment Options

When most people hear the words "precious metals investment," they immediately picture custodian-managed bullion bars or huge coin stashes. As it turns out, however, there are multiple ways for investors to hedge while using precious metals as their commodity of choice.

We've covered most of the main methods in a previous article on precious metals investment strategies. But we'll give you a quick overview of the primary investment methods here:

1. Purchasing Precious Metal Bars and Coins Directly

At this point, everyone's familiar with the concept of making direct precious metal investments. With this approach, you can purchase government-minted bars and coins that will give you control over your investments. And thanks to the internet, you don't even have to leave home to make your purchase.

Pros of Direct Precious Metals Investment:

  • You can maintain control of your asset
  • Prices are usually stable over time
  • Precious metal bars and coins can be cashed on short notice

Cons of Direct Precious Metals Investment:

  • Purchasing in the U.S. can come with tax implications
  • Dealers may charge you extra for buying and selling
  • Storage can be inconvenient depending on the size of your investment

2. Buying Precious Metals Derivatives

Earlier, we discussed how hedging could be useful for helping farmers and airlines save money. In both of those examples, we talked about futures contracts. These are a type of derivative investment that individuals and institutions alike can make.

But here's the best part:

Futures contracts, or agreements to buy or sell goods for a certain price at a later date, aren't the only form of derivative investment at your disposal. You can also trade options or forward contracts to get a similar hedging advantage.

The whole futures vs options debate is one that's still up in the air for a lot of investors. But if you value certainty and flexibility, derivatives can make it possible for you to protect your investments without having to store and maintain your collection of precious metals.

Pros of Precious Metals Derivatives:

  • You get flexibility
  • You can give yourself predictable profits
  • You can invest without having to take physical ownership

Cons of Precious Metals Derivatives:

  • Derivatives can be complicated
  • It's easy to lose money
  • Investors often have to be more hands-on when trading derivatives

3. Purchasing Precious Metals ETFs or Mining Company Stocks

As it turns out, you don't necessarily have to purchase a physical gold coin collection or learn a whole new market to hedge your portfolio. You can also log into your brokerage account and purchase ETFs that are designed to track the value of the precious metals market. And you'd be surprised at the sheer number of stocks and funds that are designed to do exactly that.

Pros of ETFs and Precious Metals Stocks

  • Can purchase at your convenience
  • Able to invest retirement and trading funds directly
  • Don't need to open new accounts or find reputable dealers to make a purchase
  • There's a variety of mining stocks and ETFs to choose from
  • Broker's fees are all that you need to be concerned about

Cons of ETFs and Precious Metals Stocks:

  • Price fluctuations can happen for reasons that have nothing to do with gold
  • Management fees and transaction costs can eat into your profits
  • Stocks and ETFs are subject to capital gains taxes
  • If market assets aren't liquid enough, you could struggle to unload stocks in the future

Which Hedging Vehicle Should You Choose?

At the end of the day, these are all extremely different approaches to precious metals investing. As such, you might be reading this and wondering if there's a right or a wrong way to invest as a hedge against inflation.

The truth is that the "right" answer will largely depend on your needs as an investor. If you're looking to lock in profits for an item you're selling or if you're a company that wants to keep costs down, the derivatives market is more than likely where you want to be.

However, for most regular folks who are just looking to mitigate loss and enjoy the benefits of a silver or gold price uptick, there's no beating the accessibility and convenience of a precious metals ETF or a similar stock. And if you're the type of person who just can't get enough of gold, silver, and platinum, you always have the option of using multiple investment methods.

Protect Your Portfolio With Precious Metals

In these uncertain economic times, inflation is becoming an increasingly common concern for investors and regular people alike. Although the typical advice to "buy gold" might sound cliche, precious metals are an extremely effective way to hedge against inflation.

As hard commodities that are often used in manufacturing and high-end items, gold, silver, and platinum are already solid investment choices. And when you consider the storied history of precious metals and their proven track record as value stores, the benefits of hedging with precious metals become all the more apparent.

Want to learn more about investing in gold, silver, or platinum? Check out our site for more valuable investing information.

Don’t miss a golden opportunity.

Now that you’ve gained a deeper understanding about gold, it’s time to browse our selection of gold bars, coins, or exclusive Sprott Gold wafers.

About Sprott Money

Specializing in the sale of bullion, bullion storage and precious metals registered investments, there’s a reason Sprott Money is called “The Most Trusted Name in Precious Metals”.

Since 2008, our customers have trusted us to provide guidance, education, and superior customer service as we help build their holdings in precious metals—no matter the size of the portfolio. Chairman, Eric Sprott, and President, Larisa Sprott, are proud to head up one of the most well-known and reputable precious metal firms in North America. Learn more about Sprott Money.

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