The Impact of Inflation on Investment Returns
- Research
- Apr 22
- 4 min read
Inflation is the bane of all money, meaning it calls into question the utility of anything from a dollar's invested return to a dollar spent on lunch. But while moderate inflation is normal in a healthy economy, high inflation can do serious damage to investments. This article discusses the effects of inflation on investments and how a portfolio can be protected. We introduce a case study on the impact of inflation on bonds and equities in the 70s.
How Inflation Affects Investment Returns
Inflation has different effects on investments with respect to the real value of returns, interest rates and asset prices.
Erosion of Purchasing Power: Inflation means that over time, money buys less. If an investor receives a 5% return on an investment but inflation is 3%, the real return is merely 2%. That makes returns worth in “real” value so an investor must factor in inflation when judging how well his or her portfolio has done.
Impact on Bonds: Inflation is especially destructive to fixed-income investments such as bonds. Because bonds provide fixed interest payments, higher inflation erodes the real value of those payments. For instance, if an investor owns a bond that pays 4% interest while inflation is 5%, that person suffers a negative real return and a loss of purchasing power.
Higher Interest Rates: Sometimes, as inflation runs high, central banks will raise interest rates. Interest rates has a significant effect on lending as higher interest rates increases the cost of borrowing, which can lead to decreased consumer spending and business investment. Moreover, the increase in rates decreases the present value of future cash flows from the stocks, resulting in lower stock market returns.
Stock Market Impact: Inflation can impact stocks in different ways. Some companies can raise prices and pass higher costs on to consumers, while others might struggle with escalating expenses. Inflation also elevates discount rates, which lowers the present value of future earnings and takes a toll on stock valuations. Inflationary period volatility can add to unpredictability stock market returns.
Strategies to Protect a Portfolio Against Inflation
While inflation is impactful, it can be tamed with the right investment approach. There are many ways to hedge against inflation:
Inflation-Protected Securities: Treasury Inflation-Protected Securities (TIPS) are inflation-adjusted government bonds. The principal value of TIPS increases in the event of inflation, which in turn means that interest payments, and the bond’s value at maturity, also increase. TIPS are suited to conservative investors with an eye to protecting their principal against inflation.
Investing in Commodities: Commodities such as gold, oil and agricultural products tend to do well during inflation periods. As the prices of goods increase, prices of commodities normally go up. During inflation, gold is viewed as the “safe haven”; during inflation, it has historically held value if it doesn’t appreciate in value when inflation rises.
Real Estate Investment: Over the years, real estate has served as a robust hedge against inflation. Property values and rents go up, too, as prices increase. Real Estate Investment Trusts (REITs) allow investors to own shares in a company that owns, operates, or finances income-producing real estate. Real estate also offers diversification, which can lower risk in inflationary times.
Equity Investments in Certain Sectors: Some sectors tend to perform better during an inflation environment, including energy, consumer staples, and healthcare. These industries can pass on rising costs to consumers without materially hurting demand for their goods. Rising commodity prices, especially, benefit energy companies.
Diversification:Spread the risk of inflation across multiple assets, sectors and regions by having a diversified portfolio. With inflation eroding the value of money, investing in a diversified portfolio can help minimise the negative effects of inflation on an individual asset class and help preserve wealth as a whole.
Case Study: The Impact of Inflation on Bonds and Equities (1970s)
The 1970s are a lesson on what inflation did to investments. In the 1970s, the US had its inflation highs, in excess of 13% in 1979.
This is what happened across various asset classes:
Bonds: The real return on government bonds in the 1970s was negative. For instance, when inflation was over 10 percent, an investor holding a 6 percent U. S. Treasury bond was losing money in real terms. The fixed payments on bonds lost value in real terms, illustrating how holding fixed-income investments can be risky in environments of high inflation.
Equities: The stock market performed poorly in the 1970s. While some companies in areas like energy benefited from higher commodity prices, the markets overall mostly stagnated. The S&P 500’s average annual return of only 5.2 percent from 1970 to 1980 trailed inflation. But the real value of stock market returns was diminished as inflation rose, creating a tricky climate for equity investors.
Commodities: Conversely, commodities excelled, with gold shining in particular. Gold prices skyrocketed from approximately $35 per ounce in 1971 to over $600 at the end of the decade. Items such as oil also rose in price, which have become attractive assets in periods of high inflation.
Insights from the Case Study:
In the 1970s, both bonds and equities were negatively affected by high inflation.
Commodities (notably gold, which provides a hedge to inflation) held value or appreciated.
Real estate, which were not tracked as often during this time, has also historically appreciated during inflationary periods.
Conclusion
The impact of inflation on investment returns is significant, as it decreases the real value of money, affecting especially fixed-income assets such as bonds. Stocks and bonds suffer during inflationary periods, while commodities, inflation-protected securities and real estate are the more protective investments. Maintaining some form of diversification across multiple asset classes, sectors and geographies can help protect a portfolio from inflation.
While inflation may be unpredictable, investors can take steps to hu, minimize its effects on their portfolios. This way, if inflation is high, you can include assets like TIPS, commodities, and real estate that are linked to inflationary periods, so you can better shield your savings and preserve purchasing power over time.
Work Cited
“The Impact of Inflation on Asset Prices.” The Balance, 2021,
https://www.thebalance.com/impact-of-inflation-on-asset-prices-5199715.
“Inflation and Its Impact on Investments.” Investopedia, 2021,
“Treasury Inflation-Protected Securities (TIPS).” U.S. Department of the Treasury, 2021, https://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm.
“Inflation and Investment Returns: A Historical Overview.” Morningstar, 2020,
https://www.morningstar.com/articles/1036748/inflation-and-investment-returns-a-historical-overview.
