How Does Inflation Impact Your Investments?
Inflation is a measurement of how fast the prices of goods and services rise. It is most often presented as the consumer price index or CPI. CPI is the aggregate change over twelve months in the weighted average prices of a shopping basket of goods and services representative of the typical consumer.
Very low or very high levels of inflation can be damaging to the economy, so most governments try to maintain a more balanced level of CPI at around 2%.
Inflation decreases your wealth
Whenever prices (CPI) increase, your money’s spending power decreases and your investment portfolio may decrease in value. If CPI is at 7%, then the chocolate bar that cost you a dollar a year ago will now cost $1.07.
To offset the impact from inflation, your investment portfolio will need a total annual return equal or greater than the rate of inflation,. This can prove very difficult to achieve, even when holding a diversified portfolio of stocks, bonds, and cash to mitigate typical market risks.
What Does Inflation Mean for Your Investments
Your general goal should be to achieve a rate of return that will meet your objectives and exceed the rate of inflation so that you are making real gains. Different types of investments react quite differently to high inflation.
With no defense, cash typically suffers the most from high inflation. While a savings account rate may be increased during periods of high inflation, it is rarely at a rate to keep up with inflation. Therefore, the purchasing power of your cash is decreased.
Bonds are considered more stable than stocks, but they provide lower returns. During high inflation bonds cannot keep up. Like cash, as prices increase, the spending power of your bond income decreases. During high inflation, new bonds are issued at higher interest (coupon) rates, making your current bond holdings (especially longer-term bonds) less desirable to potential buyers unless they receive a price discount.
While stocks are more volatile than cash and bonds, some stocks can perform well during high inflation. Earnings of some industries and companies rise along with inflation due to the increase in prices of their goods and services. Dividend paying companies can therefore help shield your portfolio from the effects of inflation, especially when the dividends are reinvested and benefit from compounding and also when companies increase their dividends due to increased cash flow during an inflationary period.
How Can You Tackle Investing in an Inflationary Environment
You can put in place investment strategies that can be used to defend against inflation and even potentially outperform in an inflationary environment. However, these investments should be a component of the long-term diversification structure of your overall portfolio and not be applied as a market-timing reaction at the onset of inflation. Your investment manager should adjust your portfolio weightings according to predetermined asset class ranges.
Real estate is thought to generally keep up with inflation. However, it may depend on the economic factors of the specific real estate sector. Investing in income-producing properties through real estate investment trusts (REITs) can provide protection against rising inflation as property owners increase rents in line with inflation.
Historically, investing in precious metals such as gold, silver, and platinum has provided a hedge against inflation. Precious metals tend to maintain their value as they are a limited commodity. Investments can be made directly or through precious metal mining stocks in your equity portfolio.
Generally, allocations to energy companies as well as consumer staples and producer goods can increase returns during rising inflation. These types of stocks typically increase as inflation increases. As well, dividend-paying stocks will continue to provide income during rising inflation, especially with some companies increasing dividends in line with inflation to meet shareholders’ expectations.
While protecting against the negative effects of inflation is important, it should not disrupt your long-term investment structure and goals. Inflation-hedging investments should be a component of your overall portfolio with weightings being adjusted appropriately within predetermined ranges as inflation starts to affect the achievement of your investment objectives.
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This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this content should consult with his or her financial partner or advisor.