Inflation is one of the keys for investors to consider in building and managing their portfolios.
When the prices of goods and services rise over time, so does the purchasing power of money. So the money spent or saved now may not buy the same goods and services in the future.
For investors, inflation matters because returns should not be viewed only in terms of the percentage earned.
What matters is the real return the investment return after accounting for inflation.
How Inflation Impacts Investments
Suppose that an investment is generating 8% in a year while inflation is 6%. The investment looks good and the returns on investment may be 8% while the real return is only 2%.
If inflation increases, the difference between investment returns and purchasing power will be even larger.
Different asset classes respond differently to inflation
Fixed-income investments such as traditional fixed deposits and certain bonds can be put under pressure when inflation is high.
If the interest earned is lower than the inflation rate, the investor’s purchasing power may decline, even if the account balance increases.
Equities, on the other hand, may protect against inflation for a longer time. Companies may be able to increase the prices of their products and services (in the long run) and therefore revenues and profits will rise with the cost. But that’s not always guaranteed and stock prices can be highly volatile.
Gold is often a hedge against inflation. During periods of economic uncertainty and rising prices, demand for gold may increase. But gold does not produce regular income and its price can fluctuate.
Real estate can also be positively impacted in some inflationary periods. Property prices and rental income may rise with prices, but the factors of interest rates, location, and market conditions are important.
Why Diversification Matters
Inflation is a reminder that diversification of the investment portfolio is crucial. The risk of too much concentration on one asset can very well increase when the economy changes.
Investors might be inclined to spread their money across stocks, bonds, gold, and other assets based on their financial goals and/or risk tolerance and investment horizon.
The right strategy also depends on whether inflation is temporary or persistent.
A short-term rise in prices may help, but long-term financial planning, and for a very long period of high inflation can be so concerning.
Focus on Real Returns
Investors should look past headline returns in terms of how much their investment is actually increasing their purchasing power.
Periodically taking stock of portfolios will help ensure your investment strategy is in sync with inflation and economic conditions.
Inflation is always on the horizon of investment, but it can be tempered and managed if asset allocation is well done, diversification is made, and a long-term strategy is taken into account.
Ultimately, successful investing is not just about growing the amount of money you have.
It’s about ensuring that your wealth continues to retain its purchasing power over time.
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