How Does Inflation Impact Investing?
The negative impact of inflation on your investments is often underestimated. However, the general increase in prices impacts everyone, including investors.
In this chapter, weâll take a look at:
Inflation is a common fear for investors and one of the most significant investment risks for individual investors. However, it can be challenging to understand how inflation impacts investing. As a result, many investors donât consider the impact that inflation has on their investment returns. Instead, they focus on the return their see in their investment account without understanding the real return of their investments.
In this chapter, you will learn the basics of how inflation works and how it affects your savings and investments.
đ§ Key Takeaways
- Inflation causes prices for consumer goods to increase. As a result, your purchasing power is reduced as you can purchase fewer goods with the same amount of money.
- Inflation is caused by an increase in the supply of money without an equal increase in the production of goods and services.
- Inflation is categorized based on the speed at which your purchasing power decreases. An inflation rate above 3% can cause severe harm to the economy.
- Inflation affects liquid assets, like cash, more than illiquid assets, like stocks. The reason is that liquid assets offer lower returns, and therefore inflation has a more significant impact on the real return of your investment.
- You can protect from inflation by diversifying your portfolio across different regions and asset classes.Â
What Is Inflation?
Inflation is an economic trend that leads to a reduction of your purchasing power due to the rising prices of consumer goods. As a result, you will be able to purchase fewer goods with the same amount of money when inflation is rising. Contrary, you can buy more goods when inflation is falling.
The inflation rate is often expressed as the percentage change in the consumer price index (CPI) and is usually measured on a monthly and yearly basis. The index measures how price changes in goods that affect your purchasing power change over time. These goods typically include gasoline and other energy sources, food, and clothing.
There has to be a clear trend of price increases across products tracked by the consumer price index. A one-time jump in the price of a product is not true inflation as there might be isolated factors, such as a price change of a supplier, which may impact this specific product only. However, if the price change leads to a larger price increase for other products, it may start an increase in inflation.
đĄ Example
You go to the grocery store to purchase a box of ten eggs. Imagine the box currently costs $1. If the current inflation rate were 10%, your eggs would cost not $1 but $1.10 by the end of the year. Therefore, you can purchase fewer eggs than you could at the beginning of the year.
The opposite effect of inflation is deflation. It causes decreasing prices of consumer goods and thereby increases your purchasing power. However, if people expect prices to keep falling, they have fewer incentives to spend their income now. As a result, deflation can have devastating effects. As people spend less money, companies earn less and therefore have to decrease wages. This spiral can lead to a repeating process of declining economic activity, lower wages, and a faster decline in prices.
What Causes Inflation?
Ultimately, the cause of inflation is the increase in the supply of money relative to the productive output of the economy. Basically, more money is chasing after fewer goods and services. Therefore, as the supply of money increases, your purchasing power decreases.
The money supply is usually increased in the following ways:
- The monetary authorities print more money.
- The monetary authorities hand out money to individuals, for example, through stimulus checks.
- The monetary authorities legally devalue the currency and therefore reduce its value.
- The monetary authorities loan out new money by purchasing government bonds from private and institutional investors in the secondary market.
In the end, inflation is always the result of an increase in the money supply. However, the increase in inflation can play out in different ways:
- The cost-push inflation increases inflation through a rise in production costs for goods and services.
- The demand-pull inflation increases inflation as a result of rising demand.
- The built-in inflation creates a wage-price spiral that causes an increase in prices.
Cost-Push Inflation
When the costs of producing goods increases while demand stays stable, it may result in cost-push inflation. In this scenario, prices will increase because it gets more expensive to produce products that could previously be made at lower costs.
There can be various reasons that may cause the increase in costs to produce goods or services:
- The price of intermediary goods used to produce a product, like raw materials and commodities, increases. Reasons for the price increase may be a decrease in supply or an increase in demand.
- An increase in labor costs, for example, through the increase of the minimum wage or newly negotiated wages for union members.
- The occurrence of unexpected events, like natural disasters or a pandemic, that cause an interruption of the supply chain.
- New laws or regulations that may increase the cost to produce goods or offer services.
- Political changes in the government impacting the economy.
đĄ Example
An accident at a major oil refinery reduces the supply of oil. As a result, the price of oil starts rising, and therefore, transport and production costs, as well as heating and energy costs, start increasing. While the demand for consumer goods has not changed due to the supply shortages, they still lead to higher prices as companies begin to increase their prices to cover increased production costs.
Demand-Pull Inflation
Economists often describe demand-pull inflation as âtoo many dollars chasing too few goods.â Unlike cost-push inflation, the increase of prices through demand-pull inflation is caused by increased demand for goods and services rather than increased production costs. As a result, high-demand products face a supply shortage, leading to increased prices.
Different reasons may lead to an increase in the demand for products:
- As a result of a growing economy, consumers feel confident in the future. Therefore, they spend and borrow more money which leads to higher prices.
- The demand for goods and services increases in other countries and cause an increase in exports. As a result, products become more expensive in local markets.
- The government spends and borrows more money, causing an increase in demand.
- The supply of goods and services cannot keep pace with the increase of the money supply by monetary authorities.
đĄ Example
The economy is doing well, and interest rates are at historically low rates. As a result, it is very easy to find higher-paying jobs or borrow money cheaply. The high availability of money causes a boom in the mining of cryptocurrencies. One key component to mining cryptocurrencies are graphic cards. Therefore, due to demand-pull inflation, the price of graphic cards rises as the supply canât keep up with the demand.
Built-In Inflation
Built-in inflation is caused by employeesâ expectations that their salary is adjusted to the price increase of consumer goods to maintain their living standards. As a result, a wage-price spiral is being created, where an increase in wages causes an increase in production costs which increases the price of consumer goods. As consumer goods have gotten more expensive, the employees then expect another adjustment in their salaries, causing a loop of price increases following wage increases.
What Types Of Inflation Exist?
Experts categorize inflation into four main types. The differentiation between these types is based on the speed at which your purchasing power decreases.
The four main types of inflation are:
- Creeping inflation
- Walking inflation
- Galloping inflation
- Hyperinflation
Creeping Inflation
When prices increase by 3% or less per year, inflation is called creeping inflation. At this rate, people expect inflation to grow in the future. As a result, they have an incentive to spend their money now rather than later. Therefore, creeping inflation is considered to be positive as it boosts economic growth and triggers demand-pull inflation.
Walking Inflation
Walking inflation occurs when the current inflation rate is between 3% and 10% per year. At this point, inflation is considered harmful to the economy. Because prices keep increasing at a fast pace, consumers are incentivized to purchase more goods than needed. As a result, companies canât keep up with demand, and prices start to rise beyond what people can afford.
Galloping Inflation
An inflation rate above 10% is extremely harmful to the economy. The negative effects of the walking inflation are increased drastically to the point where companies and employees canât keep up with the increasing prices anymore. In addition, it may lead to a negative reputation of the country amongst investors, which leads to an exit of capital needed to keep the economy and government going.
Hyperinflation
While hyperinflation is rare, it is extremely damaging to the economy. When hyperinflation occurs, prices increase by more than 50% per month. In extreme cases, prices may even double every few days or hours. Luckily though, it is extremely rare for hyperinflation to happen.
How Do Governments Control The Inflation Rate?
Governments and monetary authorities aim to control the current inflation rate in an attempt to stimulate economic growth without overheating the economy. While a high inflation rate above 3% can be damaging to the economy, a low inflation rate can actually increase demand for products without starting a wage-price spiral. As a result, most governments aim to keep inflation steady at about 2% per year.
Generally, inflation is caused when the money supply increases faster than economic growth. Therefore, the best way for the government to control inflation is to control the availability of money.
The money supply is usually controlled by increasing or decreasing interest rates. When interest rates rise, money becomes more expensive to borrow, and therefore people are more careful where they spend money. Contrary, if interest rates decrease, money becomes cheaper to borrow, and people will spend more money.
How Does Inflation Affect Your Savings And Investments?
When prices for goods and services increase, you can buy fewer of them with every dollar you have saved or invested. Therefore, the real value of your money and assets is being eroded as inflation goes up. While the numbers in your savings account or investment account do not change, the underlying value decreases. As a result, one of the main goals of saving and investing is to escape the erosion of your real purchasing power through inflation.
The current inflation rate is essential information for investors as it helps them to calculate the real return of their investments. It tells you precisely what rate of return you need to achieve to maintain your current living standard. For example, if the current inflation rate is 2% and your portfolio makes 4%, you are outpacing inflation by 2%, and the value of your assets increases. The amount by with you outpace inflation is called the real return of your portfolio.
The value of different asset classes is affected differently by inflation. Real Estate and commodities tend to rise during inflation. Equities and derivatives may also outpace inflation, but in their case, it highly depends on each investment. Cash and cash equivalents, currencies, and fixed-income securities often decrease in value during inflation as their value is directly linked to the purchasing power or because they have a fixed value.
Impact On Your Savings
The main objective of saving is to keep your money somewhere safe without risking a loss of value. At the same time, your savings should be easily and quickly accessible. As a result, you typically save using liquid assets, like cash, savings accounts, money market accounts, or certificates of deposit. Unfortunately, these liquid assets are more vulnerable to the negative impact of inflation.
If you keep your cash in a savings jar, you will not receive any interest on its value. Therefore the value of your money will continuously decrease without receiving interest payments that may outweigh the effect of inflation.
However, you can keep your savings in a savings account, money market account, or purchase certificates of deposit. In return, you will receive interest on your money. Because earning interest on your money is a very low-risk investment, the interest rate you receive on your money is typically relatively low. To keep or increase their value, the interest rate paid to you has to be higher than the current inflation rate.
Therefore, there are fewer incentives to hold liquid assets, like cash or your savings, during times of high inflation. Many companies and people will start to put their money into higher-risk assets that offer them higher rewards. Banks typically begin to offer higher interest rates on your savings when inflation rises to combat this effect.
Impact On Investments
Unlike your savings, your investments typically grow at a higher rate of return. As a result, your investments will be less affected by the adverse effects of inflation. However, the impact of inflation highly depends on the type of asset you hold.
If you purchase fixed-income securities with a set annual return, like bonds, inflation can hurt your investment performance. As you will receive the same interest payment each year, the value of the interest payments will decrease with each year that you hold the asset. This effect happens because the inflation rate reduces your real return on each interest payment. Therefore, the longer the duration of the fixed-income security, the more its value will decrease in value due to inflation.
One alternative might be fixed-income securities that are protected against inflation risk. One example are Treasure Inflation Protected Securities (TIPS) which are issued by the US government. Their interest payments go up when inflation increase and go down when it decreases.
đĄ Example
You purchase bonds with a value of $1000 and an annual interest rate of 10%. Therefore, you will receive $100 in interest payments each year. However, the current inflation rate is 2%. As a result, your real return is 8%, as you have to subtract the inflation rate from the interest rate. Therefore, the real value of your interest payment is $80 instead of $100.
While fixed-income securities are vulnerable to the effects of inflation, stocks can protect you better from the impact of inflation. However, in the case of stocks, the effects of inflation are much more dependent on each individual company. While the revenues and earnings of most companies should increase at a similar pace than inflation, some companies are more susceptible to the changes in the inflation rate. In addition, companies might be able to sell more in times of high inflation. However, they have to pay more for wages and raw materials, which increases their costs.
How Can You Protect Against Inflation?
Inflation can have devastating effects on your investments. The power of compounding is your greatest ally in increasing the value of your portfolio. Unfortunately, inflation also compounds over time. Therefore, your real return, the return of your portfolio minus the inflation rate, has to outpace inflation. Otherwise, the real value of your assets will decline exponentially.
It is impossible to escape the negative effects of inflation entirely. However, you can follow a few strategies to reduce the risk of inflation in your portfolio:
- Only keep money in low-yield investments, like a savings account, if you expect to need it within the next 3-5 years. If you have a longer time horizon, you should invest your money in high-yield investments like stocks or index funds instead.
- Reduce your regional exposure by diversifying your investments across different countries. You can reduce the risk of regional increases in the inflation rate through regional diversification.
- Diversify your investments across different asset classes. You should hold stocks or index funds to increase your portfolioâs growth and real return. But you should also invest in other assets, like inflation-protected fixed-income securities such as US TIPS.
- A small part of your portfolio should consist of assets that hold up well against inflation. Gold, for example, is typically holding up well when inflation rises. Other commodities may also protect against rising inflation rates.
- If you invest in bonds, you should diversify between short-term and long-term bonds. While short-term bonds may not offer the best returns, their interest payments are less affected by inflation than long-term bonds.
Next Chapter
Continue with the next lesson of our beginner-friendly guide âBasics Of Investingâ.