Understanding Inflation and Its Effect on Your Investment Portfolio
In most cases, people think of inflation as a general increase in the price of things and a decrease in the value of the dollar. However, in reality inflation is not such a simple phenomenon. Inflation impacts all aspects of an economy, whether it is consumer spending, investment, employment rate, government initiatives, tax policies, or interest rates. Hence, understanding inflation and its effect on your investment portfolio are critical. Inflation has the potential to reduce the worth of your investments. But if managed well and planned strategically, you can offset the impact of inflation in the long-run.
What is inflation?
Inflation is the continuous rise in the prices of goods and services in the economy. This implies that inflation leads to the reduction in the purchasing power of the dollar. For example, if a bicycle costs $100 today, and the current rate of inflation is 2%; next year the same bicycle could cost $102, assuming the rate of inflation remains constant.
How does inflation work?
Generally, as the economy grows, businesses and consumers spend more money on buying goods and services. In this stage, also known as the growth stage, the consumer demand outruns the supply of goods and services. This in turn, provides an opportunity for producers to raise their prices. As a result, the rate of inflation rises. Alternatively, if there is rapid economic growth, the demand continues to increase enabling producers to raise their prices continually.
Many economists have described inflation as “too many dollars chasing too few goods”. In this case, the spending rate is more than the actual production of goods, which results in an excessive supply of dollars in the economy. This brings a decline in the purchasing power and spikes the inflation rate.
How is inflation calculated?
For investors, there are several reported measures of inflation. However, the Consumer Price Index (CPI) is the best index for inflation in the U.S. The CPI reflects the retail price of goods and services in the economy. These goods and services are inclusive of house, transportation, and healthcare.
In some cases, the Federal Reserve prefers to consider the Personal Consumption Expenditures (PCEs) as an indication because it is more comprehensive than the CPI index. The PCE includes a broader range of expenditures than CPI.
How does inflation impact your savings?
Inflation has a direct influence on your savings and investments. Over time, inflation reduces the value of your savings because of the rise in future prices. This is most prominent in the case of cash savings. For example, suppose you have $10,000 savings (in cash), and you keep it aside to buy a car in the future. After ten years, the value of $10,000 would decrease. Inflation will eat into your purchasing power, and you might not be able to buy the car for which you saved.
But, if you keep your money in a bank account, you will get some interest, which might help to offset the impact of inflation. However, the growth might still not be enough to counterbalance inflation. Instead, you can aim to invest in instruments that either offer equal or greater returns than the rate of inflation. For example, if you have a choice to invest in the shares of ABC Ltd. offering 6% return and XYZ Ltd. offering 4% returns, you might want to consider the rate of inflation, which in this case is 5%. This effectively means that your net returns (6%-5%) will be 1% in ABC stocks and -1% in XYZ stocks.
How does inflation affect your investment portfolio?
In a general scenario, inflation poses a significant threat to investors because it chips away at the real savings and returns on investments. Inflation potentially reduces long-term purchasing power. For example, a portfolio that offers 2% returns before inflation, in an environment of 3% inflation, actually produces a negative return of -1% when adjusted for inflation.
As an investor, if you fail to protect your portfolio and make the right choice at the right time, inflation can prove to be harmful. Typically, assets that have fixed, long-term cash flows perform poorly with rising inflation. This is because the purchasing power of future cash flows reduces over time. Alternatively, assets and commodities that have adjustable cash flows, like rental property, tend to perform better with inflation.
Here is how inflation affects each constituent component of your investment portfolio:
- Fixed-income investments
- Stock or equity investments
- Real assets
As mentioned above, inflation can consume your savings even if you have secured your money in a savings account that offers an average interest rate. When you are retired and living off your limited savings, inflation is more likely to diminish your buying power. Hence, it is advisable to factor inflation into your retirement savings to make sure you have adequate funds to last through your non-working years.
Fixed-income securities like bonds, treasuries, certificates of deposit (CDs), etc., are an important part of your investment portfolio. However, the ratio of these securities to stock investments varies with your life stage, financial goal, and risk appetite. The main reason for the inclusion of fixed securities in your portfolio is the stable income stream (interest payments) these securities offer. But since most of these securities carry the same rate of interest until maturity, the purchasing power of the interest receipts falls as the rate of inflation rises. Hence, bond prices decrease when inflation shoots higher. One of the reasons for this is the fixed interest paid on bonds, also known as coupon payments. A sharp rise in inflation erodes the purchasing power of a bond’s future coupon income, thereby reducing the present value of the future cash flows. That said, in the case of Treasury-Inflation Protected Security (TIPS), inflation has a more positive relationship.
As per an analysis of the U.S. Bank Asset Management Group, stocks have held a strong ground against inflation over the last 30 years. Typically, a company’s revenues should increase simultaneously with a rise in inflation. Therefore, the prices of stocks should also advance along with the increase in the general prices of goods and services. Larger corporations have a potentially stronger relationship with inflation as compared to mid-size or small companies. That said, foreign stocks of developed nations and emerging nations tend to have a strong negative relationship with inflation.
Real estate, commodities, and other real assets tend to have a positive relationship with inflation. Energy-related commodities, such as oil particularly have a close relationship with inflation, followed by industrial and precious metals. But commodities are also more volatile than many other asset classes. Moreover, they do not produce income and have historically performed poorly compared to stocks and bonds in the long-term. That said, in the case of real estate, rents can always be increased with a rise in inflation.
To sum it up
Inflation can have a significant impact on your investment portfolio. However, if you consult a professional financial advisor, you can protect your portfolio against inflation by deploying the right investment strategies and choosing suitable investment products. Inflation might not be in your control, but planning for a good defense is always an option.