Effects of Inflation on Investments

Inflation is the increase in the price of goods and services over time. When the news reports on the latest inflation numbers, they’re generally referring to the Consumer Price Index (CPI). The CPI is a tracking mechanism managed by the Bureau of Labor Statistics (BLS) and is a simple way to measure inflation by tracking the cost of buying a basket of goods over time for average urban consumers.¹

Have you ever had a grandparent or another loved one say something like, “When I was your age, milk only cost a nickel.” If you have, hold back your eye roll because this is a perfect example of inflation.

Over time, and from generation to generation, the prices of goods and services tend to rise. It’s a natural and expected part of the economic cycle. Inflation typically only becomes a hot-button issue when it’s higher than average.

In times of high inflation, prices rise far more quickly than wages, meaning the everyday American feels the squeeze of paying more at the grocery store, restaurants, and gas station.

Inflation impacts the economy in many ways, such as:

• Reduced Purchasing Power
  As inflation rises, the purchasing power of the average person drops. Let’s say you go to the store with $20 to pick up a few groceries for a nice Italian dinner. You used to be able to buy pasta, sauce, meat, and cheese for $20. But if the cost of each item increases at 10% inflation, it will now cost you $22 for the same meal. That means your $20 has less purchasing power than it used to. If your job hasn’t given you a 10% raise during that same period, you’ll likely feel the pain of now having to spend more to buy the same items.

While conversations about inflation tend to revolve around how much more expensive things are at the grocery store, there are often far more profound impacts on your investment portfolio. Since your investments typically hold a lot of money (thousands or tens of thousands of dollars compared to the hundreds you spend on goods monthly), fluctuations in the markets due to inflation can have more significant impacts compared to the extra you pay for milk.

If your investments aren’t earning at least the rate of inflation, your future money is going to have less purchasing power. And certain investments tend to fare better than others during inflationary times.

• Impact of Inflation on Stocks
  Overall, stocks experience more market volatility during times of inflation. However, not all stocks perform the same. Some stocks in specific sectors, like energy, may perform better as those companies can pass rising costs to consumers. In any case, a stock’s real returns are lower during periods of higher inflation. That’s because real returns are the overall return minus inflation. So if a stock is up 10% for the year, but inflation is 3.5%, the real return isn’t 10%, but rather 6.5%.
• Impact of Inflation on Real Assets
  Real assets include real estate and commodities (think oil, precious metals, and agriculture). These assets tend to do well during times of inflation because so much of the cost is often passed along to consumers. For example, if the inputs for real estate rise, including land, labor, and materials, it will result in a higher property value that consumers must pay. For this reason, real estate and commodities are sometimes referred to as an inflation hedge.⁴
• Impact of Inflation on Fixed-Income Investments
  A fixed-income investment guarantees a certain interest income for a set period. Examples include certificates of deposit (CDs) and treasury, municipal, or corporate bonds. A fixed-income investment locked in at a low rate may deliver a subpar return during inflation. That’s because the return you agreed to when you purchased the asset has less purchasing power by the time the investment pays out.

When you invest money, you’re setting it aside for your future self. And whether you’re not planning to touch it for years or decades, you want to ensure it has maximum purchasing power by the time you need to use it. While there’s no foolproof way to protect your portfolio from inflation, these tips may help:

• Diversify Your Assets
  Diversification is the process of stabilizing your portfolio by ensuring you have different asset types and classes. For example, let’s say your portfolio consists of a 401(k) plan, and 100% of the money in that plan is invested in your company’s stock. To diversify your portfolio, you might sell some of your company stock to purchase other asset types, like ETFs, bonds, or mutual funds.⁵ Having an array of assets within your 401(k) helps decrease your investment risk. So, you may be better protected if inflation is a net negative for your company and its stock performance.
• Explore Inflation-Protected Asset Classes
  Treasury Inflation-Protected Securities (TIPS) are an investment that matures in 5, 10, or 30 years with a principal that goes up during inflation and down with deflation. The principal of TIPS is adjusted based on the CPI, meaning that at the maturity of the investment, you’ll get the increased price adjusted for inflation or the original price, whichever is greater. Since you can never get less than your original principal amount, this type of investment is considered “protected” from inflation.⁶
• Consider Geographic Diversification
  Spreading your portfolio’s risk across many countries could help hedge against U.S. inflation. If your investment portfolio is 100% in U.S. securities, it’s subject to fluctuations associated with inflation in the U.S. economy. Putting a percentage of your overall portfolio into international stock or bond funds could provide more stability for your investments by spreading the risk across the economies of more nations and regions.
• Look to High-Yield Savings
  High-yield savings accounts (HYSA) are a savings option that tends to be more inflation-resistant than a traditional savings account. Though they’re not directly tied to inflation, like some fixed-income investments are, the interest rates of HYSAs tend to rise with the interest rates in the broader economy, which is more likely to happen during inflation.