Inflation has become a very big problem today and is eating away at everybody’s savings. All prices have gone up, especially housing, food and other living costs. Therefore, what can you as an investor do to protect yourself in this inflationary environment?
Warren Buffett (Trades, Portfolio) has provided a lot of helpful advice on this subject. According to the Oracle of Omaha, one of the best ways to maintain your purchasing power would be to be the best at what you do. For example, if you are the leading accountant or brain surgeon in town, as he put it, you will always be able to maintain your purchasing power by bargaining for higher wages as inflation goes along. For investors, however, it is more complicated than that.
Inflation and how it affects your real rate of return and purchasing power
Your real rate of return on an investment is your return after you deduct inflation. Therefore, if today you have $1,000 and you have a 20% return, the following year you will have $1,200. However, if inflation is at 30% a year, your purchasing power is going to be 10% less even with the higher dollar amount in your bank account.
As an investor, what should you do to protect yourself in an inflationary environment?
According to Buffett, these are your alternatives going from the worse to the best option when it comes to inflation, considering that the latest inflation rate is 7.7% a year.
1) Cash gets a 0% return, so with inflation at 7.7%, if you invest in Cash, you will have a real return of -7.7% per year.
2) Fixed income government bonds. The current return for U.S. 10-year treasuries is 3.6%. Therefore, if you invest in U.S. government bonds, you will have a real return of -4.1% per year. Fixed government bonds are considered very safe investments, but in these cases of high inflation, they are not able to provide positive yields. You could protect yourself from this problem by investing in TIPS (Treasury Inflation-Protected Securities), but you would still not have the return potential of productive assets.
3) Unproductive assets. If you invest in unproductive assets, you will have a real return of approximately 0%. These assets should keep up with inflation, but nothing more than that. Some forms of these assets are also very risky because they are not determined by the value they produce but by finding someone else willing to pay you more than what you paid for it. An example of an unproductive assset is gold, which Buffett says is a very stupid investment. If he could choose between gold and productive assets, he would not want all the gold in the world (fun fact, all the gold in the world is currently estimated to be able to form roughly a cube with 60-foot dimensions). With the same value of that gold, you would be able to buy, according to Buffett's estimates, all the farmland in the U.S., seven times the market cap of Exxon Mobil (XOM, Financial) and have $1 trillion of walking around money.
2) Productive assets. The long-term annual return of the S&P 500 is about 10%, so after inflation, that would represent a 2.3% real return. However, if you want to have better returns than the usual S&P 500 ETF (SPY, Financial), you will have to invest in great businesses that work well under inflationary pressures. Buffett classifies great business by factors including asset-light business models and strong pricing power, like Apple (AAPL, Financial) and Coca-Cola (KO, Financial).
Why cash flow is king in order to have financial stability
With all of the above said, remember that during these difficult times of high inflation and potential economic stagnation, it will be cash flow and not real rate of return that will be fundamental for financial stability. You cannot spend a rate of return, and therefore you will need to have a positive cash flow in order to have sufficient income to cover all your personal expenses and grow your investing portfolio. It is therefore essential to pay particular attention to the following three codes of conduct:
1) Increase your earnings rate
As Buffett said, you need to be the best at what you do in order to maintain your earnings power. This doesn't necessarily mean "the best in the world," just the best in terms of your place in life and your employer's (or customers') needs. In periods of high inflation, being indispensible to whoever is paying for your time is the key.
2) Increase your savings rate
An individual protection is also to reduce your expenses by living a more frugal lifestyle. If you're concerned about costs, there are often ways to reduce unneccessary costs like concert tickets and fancier cars. This will also allow you to increase your cash position that you can then use for your investments, which can provide passive income.
3) Passive income
A standard S&P 500 ETF does fine for the purpose of long-term investing, but what Buffett suggests is to invest in great companies with big moats, low Capex and which are leaders in their sectors and therefore can pass on these extra costs due to inflation to their customers without risking losing market share. If an investor doesn't believe their stock-picking skills can beat the index, it may be best to stick to ETFs, but these days, the S&P 500's passive income is low due to its microscopic dividend yield. Investors looking for more passive income may therefore want to look for dividend stocks or high-yield ETFs.
