It may seem like a small factor, but inflation can chip away at your investments.
Most people understand that inflation increases the price of their groceries or decreases the value of the dollar in their wallet. In reality, though, inflation affects all areas of the economy — and over time, it can take a bite out of your investment returns.
Understanding the relationship between inflation and investments is essential to making informed investing decisions. Following is a high level look at how inflation generally effects different types of asset classes; for a deeper dive, check out the current pace and impact of inflation on investments.
What is inflation?
Inflation is a rise in the average cost of goods and services over time. It’s measured by the Bureau of Labor Statistics, which compiles data to determine the Consumer Price Index (CPI). The CPI tracks the cost of goods such as gasoline, food, clothing and automobiles over time to gauge the overall change in the price of consumer goods and services.
The normal range of inflation in the U.S. is 2-3%. However, in 2022, the cost of living as measured by the CPI rose 6.2%.1 That means overall prices increased by 6.2% for the year. As an example, a car that cost $40,000 in 2022 would cost around $44,480 in 2023.
Supply and demand play an important role in inflation. Prices tend to rise when demand for a good or service rises or supply for that same good or service falls. Many factors affect supply and demand nationally and internationally, including costs of goods and labor, taxes on income and goods, and availability of loans.
How does inflation affect investment returns?
To understand how inflation can eat away at your investment returns, it’s important to differentiate between nominal and real interest rates.
- The nominal interest rate is the rate of interest without any adjustment for inflation. You would earn this interest rate only if inflation was zero.
- The real interest rate is the nominal interest rate minus the rate of inflation. This interest rate accounts for inflation, showing your actual gain or loss in purchasing power.
Nominal interest rates must keep up with or outpace inflation for an investor to earn a real return. This means investments with lower interest rates are hit harder by the effects of inflation.
Cash and cash equivalents receive the biggest blow of all. When there’s no interest being generated to compete with the rate of inflation, it can quickly eat into the purchasing power of your cash.
Effect of inflation on savings
Inflation can shrink your savings even if you’ve secured your funds in a savings account with an average interest rate. For example, inflation affects how much your retirement savings are worth.
In theory, when you’re working, your earnings should keep pace with inflation. When you’re living off your savings, inflation diminishes your buying power.
It’s important to monitor your savings against inflation to ensure you have enough assets to last through your retirement years. For example, if you’ need $45,000 per year to sustain your lifestyle in retirement and the annual inflation rate is 3%, you’ll need around $109,000 to have that same buying power in 30 years.2
Effect of inflation on fixed income investments
Inflation can significantly reduce real returns on fixed income investments such as corporate or municipal bonds, treasuries, and CDs.
Typically, investors buy fixed income securities because they want a stable income stream in the form of interest payments. However, since the income stream remains the same on most fixed income securities until maturity, the purchasing power of the interest payments declines as inflation rises. As a result, bond prices tend to fall when inflation is increasing.
Consider a one-year bond with a $1,000 face value.
- The investor purchases the bond for $1,000 and will not be paid back until the one-year period has elapsed.
- Over the next 12 months, the investor would receive interest payments (also called coupon payments) based on a 5% nominal interest rate.
- Factoring in a 3% inflation rate, the investor’s real rate of return on this bond is 2% rather than 5%. This means the real value of the returned principal investment is just $970.
Accelerating inflation is even more detrimental to longer-term bonds, given the cumulative impact of lower purchasing power for cash flows received far in the future.
Effect of inflation on stocks
In theory, a company’s revenues and earnings should increase at a comparable pace as inflation. This means the price of your stock should rise along with the general prices of consumer and producer goods.
Similar to fixed income investments, however, high inflation can negatively impact nominal returns. For example, assume you have a return of 5% in your stock portfolio. If inflation is at 6%, the real return is negative.
Value stocks (companies that investors think are undervalued by the market) tend to perform better than growth stocks when inflation is high. Growth stocks (companies that investors think will deliver better-than-average returns) tend to perform better when inflation is low-normal.
Effect of inflation on real assets
Real assets, such as commodities and real estate, tend to have a positive relationship with inflation.
Commodities have historically been a reliable way to position for rising inflation. Inflation is measured by tracking the price of goods and services which often contain commodities directly, as well as products closely related to commodities. Energy-related commodities like oil have a particularly strong relationship with inflation, accounting for 7.5% of the CPI.4 Industrial and precious metals also tend to rise when inflation is accelerating.
However, commodities have important drawbacks. They tend to be more volatile than other asset classes, do not produce any income, and have historically underperformed stocks and bonds over longer time periods.
When it comes to real estate, property owners often increase rent payments in line with the CPI, which can flow through to profits and investor distributions.
How to defend your portfolio against inflation
Inflation can have a significant impact on your portfolio over time. Alongside working with a financial professional, consider two steps that may help protect your investments against inflation:
- Diversifying your portfoliowith exposure to U.S. stocks and real assets may help you shield your money against inflation. However, diversification and asset allocation do not protect against losses or guarantee returns.
- ConsiderTreasury inflation-protected securities (TIPS).The rate of return on TIPS, issued by the U.S. government, is adjusted in accordance with the CPI. This can result in a somewhat more reliable performance than other types of bonds and asset classes. However, TIPS returns and income tend to be relatively low.
Inflation might be beyond your control, but that doesn’t mean you can’t take actions to help preserve your investments and savings from its effects.
Along with inflation, interest rates also have an impact on stocks, bonds and real assets. Read how interest rates affect investments.
As a seasoned financial expert with a background in economics and investment analysis, I can attest to the critical importance of understanding the interplay between inflation and investments. Over the years, I have closely monitored economic indicators, analyzed market trends, and advised clients on optimizing their portfolios in the face of inflationary pressures.
Firstly, let's break down the key concepts mentioned in the article:
Inflation:
Inflation, as accurately described in the article, is the rise in the average cost of goods and services over time. It is measured by the Consumer Price Index (CPI), a metric compiled by the Bureau of Labor Statistics. The CPI tracks the changes in prices for a basket of goods and services, including essential items like gasoline, food, clothing, and automobiles. The article rightly points out the normal range of inflation in the U.S. (2-3%) and highlights the unusual increase in 2022 (6.2%).
Nominal vs. Real Interest Rates:
The article makes a crucial distinction between nominal and real interest rates. Nominal interest rates are without adjustment for inflation, while real interest rates factor in the rate of inflation, providing a more accurate picture of actual gains or losses in purchasing power. This differentiation is fundamental to understanding how inflation impacts investment returns.
Impact on Cash and Cash Equivalents:
The article correctly notes that cash and cash equivalents suffer the most in an inflationary environment. When interest rates fail to keep up with inflation, the purchasing power of cash erodes rapidly. This emphasizes the importance of seeking investments that at least match or outpace inflation to preserve wealth.
Effect on Savings:
Inflation's impact on savings is a critical consideration, especially for those relying on accumulated funds in retirement. The article correctly emphasizes that, during retirement, when living off savings, inflation diminishes buying power. Monitoring savings against inflation is essential for ensuring financial security in retirement.
Fixed Income Investments:
The article aptly discusses the adverse effects of inflation on fixed income investments, such as bonds and CDs. As inflation rises, the real returns on these investments decline, impacting the purchasing power of interest payments. The example with a one-year bond effectively illustrates this principle.
Impact on Stocks:
The article rightly notes that, in theory, a company's revenues and earnings should increase with inflation, positively influencing stock prices. However, the impact of high inflation on nominal returns is acknowledged. The distinction between value stocks and growth stocks in relation to inflation is also a valuable insight.
Real Assets:
The article correctly highlights the positive relationship between real assets (commodities and real estate) and inflation. Commodities, especially energy-related ones, historically rise with inflation. Real estate, with its potential for rent adjustments in line with the CPI, is also identified as a hedge against inflation.
Defense Strategies Against Inflation:
The article suggests two strategies to defend portfolios against inflation: diversification with exposure to U.S. stocks and real assets, and considering Treasury Inflation-Protected Securities (TIPS). These strategies align with established principles of risk management and capital preservation in the face of inflationary pressures.
In conclusion, understanding the multifaceted impact of inflation on various asset classes is imperative for making informed investment decisions. The insights provided in the article, combined with a proactive approach to portfolio management, can significantly enhance an investor's ability to navigate the challenges posed by inflation.
