Assets that may shield investors from inflation

How to stop its destructive power eroding the value of your money

INVESTORS today are spooked by the worrying combination of the Cyprus bailout, EU contagion, and the chancellor’s Budget this afternoon. But with the inflation rate at 2.8 per cent in February on the consumer price index and at 3.3 per cent on the retail price index, it could be the most egregious issue that savers should be thinking about. While people have tended to underestimate inflation’s destructive power, Tom Stevenson of Fidelity reminds us that “an inflation rate of 7 per cent will halve the value of your income in just ten years, and reduce it by three-quarters in 20 years”.

So how can you balance a desire for financial safety with the urgent need to outpace inflation?

Equities should be the first port-of-call for savers willing to take a step up from savings accounts on the risk curve. They have historically outperformed safer investments like bank accounts or bonds. Equities are a good hedge against inflation because shares represent a real claim on a company’s assets and its cash flows, which “can rise in line with prices if a company has any purchasing power,” says Stevenson.

And the FTSE 100 is currently yielding 3.5 to 4 per cent, enabling investors to obtain an inflation-beating income that can either be used to compound, or put in the back pocket to help with the increase in outgoings. Indeed, says Joel Lewis of Hargreaves Lansdown, with 97 of the 100 shares in the FTSE 100 currently paying a dividend, “the hard part is deciding which shares to hold”. For those with a higher risk appetite, emerging markets might be an appealing option, and they are forming an increasingly sizeable portion of investors’ portfolio.

But, says Darius McDermott of Chelsea Financial Planners, if you’re thinking short term, avoid equities “because prices can go down as well as up”. In this instance, index-linked gilts, which provide investors with inflation-proofed yields, may be a good option. The are backed by the government, so history suggests they are a wise choice: even after a downgrade, the British government has never defaulted on its debt. But they are generally overvalued, and unless you’re buying very short-dated gilts, are unlikely to deliver returns. This may suit a risk averse investor, or one with a short-term timeframe, but if you don’t fit these categories, where else can you look?

Gold – which can either be bought physically, through an exchange-traded fund (ETF), or through gold equities – has traditionally been seen as a good hedge against inflation and the debasement of currencies. However, there is no yield on a bar of gold – unlike shares that may pay dividends, or bonds that pay a coupon. And there is growing concern that gold itself may be overvalued.

Looking elsewhere in the commodities class, oil – which investors can get exposure to through stocks, ETFs or funds – should be pursued with caution. The “black gold” is a hugely volatile investment, so investors with stocks in an oil company should consider spreading their investments. But it has a low correlation with equities, could inject some much-needed diversification into your portfolio, and be a good hedge against inflation.

The recent gold bull run – which has lasted a decade and seen the price leap from $200 to $1,600 per ounce – may mean you opt for alternative investments, like wine and art. But these should only be pursued by the more sophisticated, wider portfolio-holders, as they are unregulated and can be highly volatile. But without going into anything volatile, “it’s unlikely investors will get an above inflation return,” says McDermott.

These alternatives may beat inflation specifically because they are scarce, with only a limited supply available that will likely surpass demand. Wine has returned 9.8 per cent per year since 2001. Further, says Chris Smith of the Wine Investment Fund, if you take the index back to 1988 and look at every possible five year period, wine has only made a loss in one ­– of 1 per cent. If you do the same exercise on the FTSE 100, it has made a loss in 75 of the 242 total periods – of 39 per cent in one instance.

If this sounds tempting, beware certain pitfalls. While wine can be bought and sold free of VAT and duty, provided it is stored “in bond” in a warehouse, if you choose to store it at home, or release it to drink, that exemption won’t apply. With increased interest from emerging markets – and China in particular – wine is becoming an increasingly expensive investment and, like shares, it can drop in value. But it wouldn’t be a complete loss, you could at least quaff the negative equity.

Similarly, if classic cars tickle your investment fancy, there are additional costs and considerations to bear in mind. Running costs – such as insurance and fuel – can be high. And the dramatic increases in value reported by the Historic Automobile Group – which reported a soar in valuations of 25 per cent in 2012 – will only apply to certain makes and models.

With annual sales of art at Christie’s, the auction house, reportedly £3.92bn in 2012 (up 10 per cent from 2011), art may be one to watch. But it isn’t guaranteed to deliver big returns, and you will also need to pay an insurance premium, high storage costs, and auction fees. And a lack of market transparency – Christie’s announced private sales of £631.3m in 2012 – makes it tough for outsiders to gain insight.

A better option may be property: retail property has experienced a 20-year bull market and the London property market is still booming. The key is to find an “up and coming area” – in London, the experts have listed Bermondsey and the development at Nine Elms – to get good valuation. But Jason Hollands of BestInvest highlights concerns over sterling depreciation, which could significantly impact on the value of your investment. Instead, he points to different real assets: physical infrastructure projects, like road, prison, and hospital building programmes. They can be accessed via listed investment companies. “We like HCL infrastructure, which has a 5.7 per cent yield; and John Laing infrastructure, yielding 5.4 per cent,” he says.

Regardless of your risk tolerance, or your appetite for fine wines, the two key considerations for all investors when buying any asset must be its valuation, and its future prospects.