Inflation is a force that impacts almost all parts of the economy, and unfortunately, your investments are not exempt. When prices increase over the long term, the value of your money falls. While this is a natural part of economic growth, it can create real dangers for your investment portfolio. Knowing the effects of inflation on your investments and taking preventive action to guard them is the key to protecting and increasing your wealth.
In this article, we’ll guide you through how inflation impacts your investments and share practical tips to help you protect your portfolio.
What Is Inflation, and How Does It Affect Your Investments?
Before we get into how inflation affects your investments, let’s first define what inflation is. Inflation is the overall rise in prices of goods and services over a period of time. When the cost of living goes up, money becomes less valuable. That is to say, you will require more money to buy the same goods and services in the future compared to today.
Inflation directly impacts your investments since it can reduce the return you receive. For example, if you have an investment in a bond that pays a fixed rate of return, and inflation increases substantially, the real return on your investment (inflation-adjusted) goes down. In effect, inflation reduces the purchasing power of the income you receive from your investments.
Let’s break it down further:
- Stock Market: Inflation can influence the stock market in several ways. When inflation increases, businesses experience increased operating expenses, including wages and raw materials. If businesses are unable to transfer these expenses to consumers, their profits can decrease. Consequently, stock prices could fall, impacting your equity investments.
- Bonds: Bonds are especially sensitive to inflation since they provide fixed interest payments. When inflation increases, the real value of these payments decreases, and bonds become less desirable for investors. This is even more so for long-term bonds.
- Real Estate: While real estate can be an inflation hedge, it’s not totally immune. It’s true that property values may rise in line with inflation, as can interest rates. This can reduce the cost of mortgages and, hence, reduce the appeal of real estate investments.
- Commodities: Commodities such as gold, oil, and other raw materials perform well under inflationary times. These physical assets have inherent value and are able to serve as a hedge against inflation because their prices increase when money value decreases.
How Inflation Reduces the Real Value of Your Investments
Let’s take a look at this through a simple example. Assume that you buy a fixed-rate bond that guarantees you 5% interest annually. If inflation is at 3%, your true return is 2% (5% – 3%). In effect, inflation takes away from the purchasing power of the return you’re receiving.
In the long term, if inflation keeps going up and your investments fail to match it, you may lose real value. What this means is that the money you expect to grow for the future might not be sufficient to achieve your desired goals, including retirement or the purchase of a home.
How to Protect Your Investments from Inflation
Now that we know how inflation affects your investments, let’s discuss how to protect yourself from it. The good news is that there are various methods that will allow you to hedge against inflation and preserve the value of your portfolio.
1. Invest in Stocks with Strong Growth Potential
Historically, shares have been one of the best long-term investments to follow or overcome inflation. Even though inflation can devastate individual companies, overall market indices have tended to rise over the long term. By investing in shares of companies that have high growth potential, you can ensure your investments have a better chance to overcome inflation.
Look for companies with a track record of growth in revenues and profits since these will be best positioned to weather inflationary pressures and keep growing. Stocks also tend to adjust to inflation over the long term since companies increase prices to compensate for higher costs. For further information, see finance articles that explore more in-depth how to weather inflation with stock investment.
2. Consider Inflation-Protected Securities
If you’re concerned about inflation eroding your fixed-income investments, consider inflation-protected securities such as Treasury Inflation-Protected Securities (TIPS). These are government bonds designed to adjust with inflation. The principal value of TIPS increases with inflation, and interest payments are based on this adjusted principal, ensuring that your return keeps up with inflation.
3. Diversify Your Portfolio
Diversification is one of the guiding rules of investment, and it’s particularly crucial during periods of inflation. By diversifying your investments into different classes of assets—stocks, bonds, real estate, and commodities—you can minimize the likelihood of any one investment being dramatically affected by inflation.
For instance, if inflation increases the price of raw materials, commodity investments such as gold may do well, offsetting any losses in other sectors of your portfolio. Diversification protects your investments by making no one asset class overwhelm your portfolio, lessening the effect of inflation on your overall return.
4. Invest in Real Estate
Property has always been viewed as a suitable hedge against inflation. The price of property will go up with inflation, and rents will often do the same. When living costs rise, so does demand for rental housing, which can give you a regular income.
If you are not yet prepared to invest in property, you can put your money in real estate investment trusts (REITs), which enable you to be invested in real estate without having to own physical properties. REITs tend to do well during inflationary times because they are secured by tangible assets—properties that appreciate over the years.
5. Keep an Eye on Interest Rates
Inflation and interest rates are also intricately connected. If inflation rises, central banks can increase interest rates to try to control it. Higher interest rates can cause borrowing to become expensive and lower the speed of the economy, which could injure some investments, especially ones that rely on cheap credit.
To shield yourself, think about focusing on investments less vulnerable to interest-rate fluctuations such as dividend-paying stocks or investments that can gain from increasing rates such as interest-rate-sensitive stocks (banks, for example). Also, remain informed about international issues since world economic happenings have a direct bearing on inflation and interest rates, which then influence your investments.
6. Invest in Commodities
Commodities like gold, silver, and oil tend to perform well during inflationary periods. These physical assets often hold their value or even increase in price when inflation erodes the purchasing power of paper currency. If you’re looking for a way to protect your investments, consider adding commodities to your portfolio.
Gold, specifically, is referred to as a “safe-haven” investment that investors rush to in periods of inflation or economic instability. It’s a means of maintaining wealth when conventional currency depreciates.
Final Thoughts
Inflation is a natural component of economic cycles, but it doesn’t have to work against your investments. With an awareness of how inflation influences your portfolio and proactive action to defend yourself, you can help preserve the value of your investments in the long run.
Keep in mind that the secret to insuring your investments against inflation is diversification, placing investments in growth assets such as stocks, and venturing into inflation-protection securities like TIPS. Commodities and real estate can also be useful hedges against inflation.
By remaining knowledgeable and making changes to your investment strategies when necessary, you can protect your financial future and allow your investments to continue working for you, even during periods of increasing inflation.