4 Effects Inflation Has On Investments
Simply put, inflation refers to a sustained trend of prices rising each year. The rate of inflation affects the entire economy, including investments. It represents how your investment’s real value deteriorates and the decrease in purchasing or spending power from one year to the next.
Like most investors, you have a specific standard of living you hope to maintain, and inf
What Is Inflation Exactly?
If money supply outpaces productive output in the economy, inflation ensues. When more money is chasing fewer available goods, it generally leads to rising prices. In other words, each money unit declines in purchasing power.
What Is an Example of Inflation?
Let’s use an illustration to explain the economic concept of inflation more thoroughly. For example, if your favorite pizza shop sells slices for $3 apiece and the inflation rate is 10%, the same slice of pizza would cost $3.30 the following year (10% more).
Following that theoretical example, you will not be able to purchase as many slices the next year unless your income increases to match the rate of inflation.
What Causes Inflation?
Inflation is when there is more demand for a good or service than availability. Also called “demand-pull inflation,” this causes prices rise. When the costs of producing goods and services increase, it can also cause inflation.
Producers must raise the sales price to account for the higher production costs and maintain a specific margin called “cost-pull inflation.”
With that said, price increases are not always due to inflation. Many factors — such as a new sales tax or a hike in oil prices — can cause businesses to raise the prices of their goods and services. But if it leads to wages and additional costs rising, it can cause a wage-price spiral, leading to true inflation.
In the same sense, one product becoming more expensive is not necessarily inflation either. It could simply be a relative price change due to a decrease in supply for the product or a company’s change of strategy.
Ultimately, inflation demonstrates that too many dollars are chasing too few products or services.
How Are Assets Affected By Inflation?
As the rise in the prices of goods and services in the economy rises over time, it can negatively affect your investments, including those in your bank account, retirement funds, certificates of deposit, and others.
One figure that investment experts calculate when figuring out the rate of return for a portfolio is the “real rate of return.” This refers to the return you can expect after adjusting for inflation. Over the past 100 years or more, the U.S. has experienced roughly a 3% average annual rate of inflation. However, inflation tends to fluctuate in the short term.
Most of the time, it slightly shifts, but there are times it fluctuates dramatically. For example, the U.S. inflation rate was around 1.23% in 2020 over the previous year. But the prices of many consumer goods and services increased by over 5% from 2020 to 2021.
It’s a natural reaction to look for ways to modify your portfolio's asset allocations when inflation is increasing. Some investment opportunities weather the storm better than others when inflation is rampant, but sometimes it isn’t necessary to make drastic changes. It’s critical to do plenty of research and understand how inflation impacts your specific assets before making any decisions.
How Do Authorities Manage Inflation?
Governments use a few strategies to control inflation. Sometimes, they are effective, while other times, they prove fruitless or cause more problems. For example, the federal government can enforce price and wage controls. The problem is that doing so violates the nature of free markets and can cost people their jobs and even cause recessions.
Central banks try to keep inflation down. Their go-to strategy is to reduce the money supply via monetary policy measures.
4 Potential Effects of Inflation on Your Investment Portfolio
The impact of inflation investments is complex. Generally, however, if your assets have fixed, long-term cash flows, they will likely struggle as inflation increases because the purchasing power of those cash flows declines during inflation.
On the other hand, assets and commodities with adjustable cash flows often thrive in inflationary environments. Here are four ways that inflation can impact your investments:
1. How Inflation Affects Fixed Income Securities
Bonds, CDs, and treasuries are some of the most common fixed-income investments. Individuals usually purchase these securities to gain a consistent income stream through interest payments.
The problem is that most fixed-income securities maintain the same interest rate until maturity, and inflation can cause the purchasing power of the interest payments to fall drastically. Therefore, bond prices typically decline anytime inflation is on the rise.
If you have invested in bonds, you probably receive coupon or fixed-interest payments. As inflation causes the purchasing power of a bond’s coupon income to fall, it naturally reduces the present value of its future cash flows. If inflation is rampant, it can be even more damaging to long-term bonds. You’re not set to receive cash flows until many years down the road, and with a lower purchasing power, it all adds up to bad news!
Many financial experts recommend going with high-yield bonds that, though riskier, offer higher incomes. These types of bonds provide a bigger cushion when inflation is accelerating.
2. How Inflation Affects Stock Investments
Stocks tend to fare better than fixed-income securities in inflationary environments. Theoretically, a business’s earnings and revenues should keep pace with inflation. In other words, your stock’s price should increase alongside the general prices of producer and consumer goods.
For the most part, U.S. stocks rise in price with accelerating inflation. While this has proven true for the past 30 years, the relationship between stock prices and inflation has not been very strong.
Larger corporations usually experience a stronger relationship with inflation than mid-sized businesses, and mid-sized businesses show a stronger connection than smaller ones. When inflation increases, the price of foreign stocks in developed markets often declines, while the price of emerging market stocks drops even more.
Buying stocks is not the most effective investment strategy in accelerating inflation environments. But if inflation is moderate, stocks can provide investors with some perks.
Inflation Can Cause You to Overpay for Stocks As discussed, some companies will raise their prices in response to inflation. But those that cater to a global market might lose their competitive edge over foreign producers that are less impacted by inflation and, therefore, don’t have to adjust their prices.
Moreover, inflation increases prices without corresponding value increases, which spells a bad deal for investors. It pretty much means that you pay more for less. Since a business’s earnings and revenue increase with the rate of inflation, its financials can be overstated.
For this reason, it's essential to do your due diligence and ensure you are not overpaying for stocks.
Inflation Can Muddy the True Value of Your Earnings As inflation falls, it brings the inflated earnings and revenue with it. It sounds simple enough because, after all, inflation impacts the whole economy as it rises and falls. However, there’s no getting around that it makes it challenging to assess the true value accurately.
The federal government uses short-term interest rates more than any other tool to fight inflation. It essentially makes it more expensive to borrow money so it can reduce the market’s excess capital.
Remember that inflation occurs when too many dollars chase too few goods (or services). If there is less money in the market, it will theoretically slow the cycle of price increases.
3. Real Assets
Real assets (like commodities and real estate) often perform well in inflationary environments. It’s hard to beat commodities if you look for investment opportunities to hedge against rising inflation. This is because inflation commodities are often directly connected to goods and services by which inflation is measured.
For example, oil, precious metals, and industrial commodities demonstrate some of the strongest relationships with inflation, and their prices usually increase as inflation accelerates.
With that said, it’s critical to consider the drawbacks of investing in commodities. They usually come with more volatility than most other asset classes, and they do not produce income. Also, they tend to underperform stocks and bonds over prolonged periods.
Real estate can prove to be a reliable investment in times of heightened inflation. If you own an investment property, you can increase the rental rate as the price of goods and services rises. This can help you maintain profit and position you for healthy investor distributions. The same can also go for wine investments, as prices rise for general goods, the price of wine has historically risen in a similar manner.
4. Savings Accounts
Finally, you must know that inflation can potentially damage your savings; that's whether or not your savings account has an average interest rate. In your working years, your earnings should theoretically match the pace of inflation.
But inflation causes your buying power to decline when you are living from your savings. Be sure to consider inflation so that you position yourself with enough assets to carry you through your golden years.
Inflation can significantly impact the real value of your investments, along with your purchasing and spending power from year to year. If you want to maintain or achieve a specific standard of living, knowing how inflation affects your investments will help you develop an intelligent strategy for the present and future.
If you want to invest in a low-volatility asset that has performed well historically, consider adding fine wine to your portfolio. Vint can help you add affordably priced SEC-qualified shares to your portfolio now.
Sources: How Inflation Erodes The Value Of Your Money | Forbes You Decide: Should Price and Wage Controls Be Brought Back? | College of Agriculture and Life Sciences Inflation hit a 31-year high. 7 pros on how they invest during high inflation | MarketWatch