How Does Inflation Affect Investments?
After several months of high inflation, you might feel like you’ve been pushed off track financially. And you’re not the only one. In 2022, inflation has almost reached double digits in developed economies, and the highest in 40 years. Because inflation shrinks consumers’ purchasing power, it also affects the economy and nearly every aspect of personal finance. This can be incredibly challenging to experience.
Thankfully, there are some things you can control. By taking a fresh look at your finances and learning how inflation affects investments, you can get a better idea about what kind of investment choices might help you protect against inflation. Although high inflation won’t last forever, and investments are a long-term strategy, diversifying your portfolio and strengthening your household finances can be wise in any environment.
Let’s look at inflation and what kind of influence it can have on different investments, so you have the information you need to make wise financial decisions.
How Does Inflation Affect Investments?
In the long run, low to moderate inflation is normal and the prices of investment assets can rise along with goods and services. However, an environment of high inflation generally hurts many investments, such as stocks and bonds, but can be positive for other investments, such as certain Treasury securities and real estate.
Inflation & Equities
While equities are generally good investments for fighting inflation over time, high inflation can negatively affect them. For this reason, equity prices tend to be volatile during periods of high inflation.
Market volatility during inflation occurs because stock prices are largely based on investor expectations of companies’ future earnings, and extreme inflation can make it difficult to accurately gauge company valuations. For example, companies with high levels of debt may be worse off during inflation because higher borrowing costs can reduce their profit.
In the first half of 2022, the stock market, as measured by the S&P 500 index, fell by more than 20%, which officially made it a “bear” market. However, as measured by NASDAQ 100 index, growth stocks fell by more than 30%.
Inflation & Bonds
Since higher interest rates generally accompany higher inflation, an inflationary environment can hurt fixed-income securities, such as bonds and mutual funds invested in bonds. This is because bond prices tend to move in the opposite direction of interest rates.
Some bonds and bond funds are affected more than others during periods of high inflation and rising interest rates. Typically, the longer the duration of the bond, the greater the interest rate sensitivity. Therefore, long-term bonds will generally suffer greater price declines than short-term bonds during high inflation.
Inflation and Real Estate
Inflation affects real estate primarily because of rising interest rates that affect the price of mortgages. However, apart from the price of mortgages, real estate is an asset class that usually performs relatively well during inflationary, rising-rate environments.
Areas of real estate that can perform well during inflation include income-generating residential with leases linked to the cost of living and industrial real estate sectors. Growth in these areas can outpace inflation because of the ability to raise rents and growing demand.
Why Are People with Savings Hurt by Inflation?
People with low-interest savings accounts, money market funds, and certificates of deposit (CDs) can be hurt by inflation because it cuts purchasing power. More specifically, if the interest rate for your savings account is lower than the rate of inflation, you are effectively losing money over time.
Furthermore, higher inflation may translate to lower savings rates or cause more people to draw from their savings accounts to keep up with the rising costs of goods and services.
How to Protect Your Investments Against Inflation?
One way to approach investing during inflation is to diversify your portfolio. Through diversification, you can potentially reduce market risk by spreading your money across different asset types. For example, you can increase exposure to investment assets, and real estate, which can be good inflation hedges.
You may also reduce exposure to other investments, such as growth stocks and long-term bonds, which typically do not perform well during periods of high inflation.
Examples of potential inflation hedges include:
- Supported Living Funds
- Real estate (not initiation)
Inflation is normal in any economy. However, high inflation significantly shrinks the purchasing power of consumers and businesses, which can negatively impact our household finances. It’s not a reason to panic, but it can prompt you to rethink and adjust your investment portfolios.