Buck Jordan here.
The first couple months of 2022 have produced some of the most complicated investing environments I’ve seen in more than a decade.
There are dozens of factors daily that shape which investments will do well and which will do poorly throughout the next few years. One of the biggest of these is high inflation rates.
I’ve been worried about the impact of inflation for investors for a while and warned earlier this year that it would be one of 2022’s top investing risks.
With May’s Consumer Price Index (CPI) measure coming in at a 1% increase for the month and more than an 8.6% increase over the last 12 months, it’s safe to say inflation is raging throughout the United States today.
Everywhere you look you see the signs of the steep inflation we’re facing.
The median sale price of a home in the U.S. has increased from $329,000 in the first quarter of 2020 to $428,000 in the first quarter of 2022 – a 30% increase in just two years! Similarly, median rents crossed $2,000 for the first time, while the average national gas price crossed $5 a gallon for the first time ever.
Inflation is one of the great destroyers of wealth and standard of living.
At its core, inflation is the rise in general prices in the economy and cost of living. In inflationary times, everything becomes absolutely and relatively more expensive. Rising costs eat away at our purchasing power, which hurts consumers and the companies that supply them.
So how can you adapt in times of inflation? How can you counteract as much of the effects of inflation as possible?
While it certainly makes sense to revisit your expenses and trim any imprudent spending, the reality is cutting costs is not going to help you fight inflation.
To truly counteract inflation, you have to invest your cash into assets that appreciate faster than the rate of inflation.
One good potential inflation hedge are stocks. On average, U.S. inflation has been 3.6% in the period between 1958 and today. During that time, the average annual return for the S&P 500 has been a very healthy 10.5%. Once you net out the effect of inflation, the average annual return of the S&P 500 for investors is about 7%.
Even in today’s environment, with inflation running nearly 3X as high as the historical average, the S&P 500’s historical annual return would still allow you to hedge the costs of inflation and grow your wealth at the end of it.
But, inflation also makes stocks volatile, so unless you have the stomach for it, there is a better place to hedge the effects of inflation. That is by investing in early-stage startups.
Startups can be a compelling inflation hedge because, as companies targeting big unsolved problems, they’re designed to grow extremely rapidly – 50%, 100%, 200% a year. The right startups can turn into home runs and even give you that coveted 100X return.
In fact, venture capitalists – such as myself – frequently outperform the S&P 500.
But don’t just take my word for it. A recent working paper from the National Bureau of Economic Research identified that 50% of VC funds outperformed the S&P 500 throughout the last 20 years.
Even more interestingly, this paper only includes data up to 2019. That means 2020 and 2021, which were both record-breaking years for VC returns with more than $1 trillion in exit value created by VC-backed companies, aren’t even included.
A couple features of startup investing makes it a compelling hedge against inflation:
- High Growth and Cutting Edge: Startups are high-growth businesses that aim to disrupt legacy companies and capture new and existing markets
- Outperformance: Half of VC firms outperform the S&P 500 because startup investing offers the opportunity to generate outsized returns
- Illiquid: Building great startups takes a decade or more of hard work, with plenty of ups and downs. Unlike public stocks, where the price varies every second of every business day, startup shares are very illiquid and far less volatile, giving investors more peace of mind
With inflation likely to stay elevated above the historical average for a long time to come, it’s time to start factoring it more heavily into your investment decision-making process.
Startups are a great way to hedge the costs of inflation by safeguarding and growing your capital strategically. Just remember: When investing in startups, keep these three tips in mind to maximize your returns. As always, do your due diligence, understand the product and market, and then see if the numbers stack up before making an investment.
One thing is for sure: when inflation is high, the last thing you want to be holding a lot of is cash.
Now’s the time to invest in startups to hedge!