Top 10 tips and tricks to inflation-proof your portfolio

On the back of the latest statistics showing that inflation is now running at 9%, we outline top tactics to protect portfolios.

A year ago, when central bankers were insisting that inflation would prove to be transitory, some fund managers, including those who manage Ruffer (LSE:RICA) and Capital Gearing (LSE:CGT) investment trusts, were preparing portfolios for a prolonged period of high inflation.

Last April, the Consumer Prices Index measure of inflation stood at 1.5%. It has now hit 9%, which is its highest level in four decades. The sharp rise in electricity and gas prices, following energy regulator Ofcom increasing its price cap, was the key factor behind a sharp monthly rise, with inflation at 7% in March.    

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• Ian Cowie: the investment trusts that pass the 9% inflation test

Over the past year, we have written various practical pointers on how investors can build in some inflation protection to their portfolios. Below, we round up our top 10 tips and tricks.

Hold your nerve, and play the long game

The first point is that, for those who can afford to, investing rather than keeping money in a cash account is your best chance of beating inflation. Equities, while riskier than cash, are growth assets, which have historically outperformed inflation over the long term.

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The latest Barclays Equity Gilt Study shows that over the past 50 years UK equities have averaged returns (after inflation) of 5.3% a year. 

• Top 10 things you need to know about holding cash versus investing

Keep cash exposure low

In stark contrast, over the same time period and after inflation had been stripped out, cash returned 1%. While cash is less risky than the stock market, it would be a mistake to think that it is ‘risk-free’ due to the effects of inflation, which erodes its purchasing power.

• Consumer staples shine as inflation soars – but can the boom last?

Reinvest dividends

The power of reinvesting dividends makes an enormous difference to long-term investment growth, as the effect of compounding works its magic. Compound growth refers to the way investment returns themselves generate gains. For instance, if you invest £1,000 into a fund returning 5% over one year, you'll earn £50. Assuming that you don't withdraw any money, the next year you'll earn 5% on £1,050, which is £52.50.

This doesn't sound like much of an uplift, but as each year passes, the compounding effect multiplies. The effect becomes even more powerful when compounded growth is bolstered by the reinvestment of dividends. Over the long term, dividend growth is where most returns come from.

Fund investors buying an income fund need to be careful about their share class choice, as our infographic below explains.

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Take advantage of the investment trust structure

Investment trusts are arguably a better option for income-seekers looking to reinvest their dividends for the long term, due to their ability to hold back up to 15% of income generated each year for a 'rainy day'.

During both the global financial crisis and the Covid-19 pandemic , most UK equity income investment trusts were able to maintain or grow their dividends, whereas nearly all UK equity income open-ended funds with an income focus cut their dividends.

• Five reasons why investment trusts are different from funds 

Target shares or funds with plenty of pricing power 

The key ingredient many fund managers look for in a company to combat inflation is pricing power – price-makers rather than price-takers.

At the end of last year, we highlighted funds and trusts focusing on pricing power as a theme, and named some of the shares they are backing to pass on increases in the cost of living.

• The UK consumer shares this UK fund manager is backing 
• How to find 'cockroach shares' that can survive disasters  

Real assets

Real assets, such as infrastructure, property and gold, have historically acted as impressive long-term hedges against inflation.

As part of a diversified portfolio, real assets can help to reduce risk alongside generating income. Our recent analysis of real assets explains in more detail, and picks out some fund and trust ideas.

• Recessions are becoming more likely – here’s how to invest

Commodities

Commodities is another play, with the history books showing that the asset class is one of the most positively correlated with inflation.

Commodity prices have been on the rise since the start of 2020, driven by the global green revolution. Russia’s invasion of Ukraine had the effect of pushing prices up further.

• Why commodities excel as inflation hedges

Wealth preservation trusts

Multi-asset trusts that invest in a cautious manner are another good option for inflation hedging. Four “wealth preservation” trusts with plenty of defensive armoury are Ruffer, Capital Gearing, Personal Assets (LSE:PNL) and RIT Capital Partners (LSE:RCP).

As our recent analysis shows, Ruffer and Capital Gearing come out on top for protecting capital. 

• Tips for recession-proofing a portfolio: where to start?
• Ian Cowie: five trusts outpacing and yielding above inflation

Consider funds and trusts with an inflation-beating objective 

Some investment trusts explicitly target inflation as a benchmark for their performance, including the aforementioned Capital Gearing and RIT Capital Partners. 

Other investment trusts aim to grow their dividends at a faster rate than inflation, including Bankers (LSE:BNKR) and Scottish American (LSE:SAIN). Both trusts are ‘dividend heroes’, having raised payouts every year for 55 years and 48 years respectively.

While, of course, there no guarantees, particularity with prices soaring, having an inflation target may be a source of comfort.

• A tactic to ride out the inflation storm using these funds and trusts

Be picky over your bond fund choices 

Inflation is a bond’s worst enemy, as it erodes the purchasing power of the fixed income that bondholders receive.

When inflation is high and interest rates are moving upwards, long-duration bonds suffer the most. Duration is the sensitivity of a bond, or bond fund, to any change in interest rates.

Long-duration bonds typically have a lifespan of 20 to 30 years.

Bonds with a shorter lifespan are less risky since there is less time for things to go wrong and less time for the economic environment to change.

Therefore, a way to mitigate risk is to consider bond funds that hold bonds with short lifespans - those that are a couple of years away from maturity.

Check out our recently written guide on the bond funds best placed to weather rising levels of inflation and increases in interest rates.