How Does Inflation Affect Investments?
Inflation. It seems like that is all we have been talking about for the last three years. We know it is all over the headlines, but do we really understand it? Why should we care? Should we be worried about the impact that inflation has on our investments?
First, let’s break down what inflation is to make sure we are all on the same page here.
In simple terms, inflation refers to the rate at which the general price level of goods and services in an economy increases over time. When inflation occurs, the purchasing power of your money decreases, which means that the same amount of money can buy fewer goods and services.
Ok, we get that part. We have all been feeling the effects of inflation around us. Everything is more expensive and most of us have probably needed to tighten our belts this year because of it.
So, let’s talk about why we are experiencing such high inflation right now.
The pandemic. Yeah, ok, we have all heard that already too but just to break it down:
In short, if the demand for goods and services is higher than the available supply, prices can increase. The Covid supply chain disruptions reduced the availability of goods and services, resulting in more demand and not enough supply, leading to higher prices.
Now that we are all on the same page let’s talk about how inflation can affect your investments.
It decreases your real returns. Inflation can decrease the real returns of your investments. For example, if you invest in a bond that has a fixed interest rate of 3%, but inflation is at 4%, your real return is negative 1%. This means that even though you earned a positive return in nominal terms, you actually lost money in real terms.
Higher costs can decrease company profits. Inflation can increase the costs of goods and services, which can impact the profitability of companies you have invested in. For example, if a company has to pay more for raw materials, it may have to increase the price of its products, which can lead to a decrease in demand and lower profits.
It influences the actions of the Federal Reserve. This is a big one. One of the ways that the Fed tries to control inflation is by reducing the amount of money in circulation. If it costs more to borrow money, consumers theoretically will spend less money. Also known as- you guessed it, increasing interest rates. Interest rates are negatively correlated with the market price of bonds. As interest rates have been steadily increasing, the price of bonds have been dropping. This has resulted in a year where both stocks and bonds were negative, which is a historically rare occurrence. Statistically, stocks and bonds act in opposition of each other which is one of the reasons we typically have both stocks and bonds in a portfolio. They can help smooth the ride and give you more ability to take advantage of opportunities in the market.
It’s not all bad news though. If we look back at previous years of high inflation, the stock market on average has been up 21.3% one year later.
Fixed income is also finally paying higher yields. Think about it, if you are the one loaning money when interest rates are high, you are getting a higher interest payment in return. We can even purchase CDs with between 4-6% interest rates right now, which has been unheard of over the past decade. Just make sure they are FDIC insured and be sure to shop the market for the best rates.
Finally, stock prices are down which means you can pick up companies at a deep discount right now! We all love a good sale but it can be harder to act on a sale when we don’t understand it. Follow the big guys. What are they doing with their money right now? It is JP Morgan’s famous quote- when you see blood in the streets, you buy. It sounds morbid but it is true. We all know to buy low and sell high, but it is much easier said than done.
If there is one thing we know, the stock market is like a roller coaster. We get the momentum to come up, after coming down. We have to be willing to ride the ride to get to the top. So as long as we are in it for the long run, we shouldn't be losing sleep. But what if we don’t have a long-term horizon? Are there things we should be doing right now to protect your investments from the negative effects of inflation?
Diversify your portfolio to include a mix of assets that can provide protection against inflation, as well as assets that can perform well in different economic conditions.
Asset allocation: Inflation can impact your asset allocation strategy. For example, if you have a portfolio that is heavily invested in bonds, which are typically negatively impacted by inflation, you may need to adjust your portfolio to include more assets that can provide protection against inflation, such as stocks or real estate.
In conclusion, inflation can have a significant impact on your investments. By understanding how inflation works and taking steps to protect your investments, you can help mitigate the negative effects of inflation and achieve your long-term investment goals.
Remember, building wealth takes time. It's important to be patient and disciplined. Don’t feel like you have to do this alone- we are here to provide education, professional guidance, and to help keep you on track during periods of uncertainty.
*The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.