The Impact of Inflation on Investment Returns

How Inflation Affects Investment Returns

Inflation affects investments by relating to the real value of returns, interest rates and asset prices.

• Erosion of Purchasing Power:As a general rule, inflation causes the purchasing power of money to decline over time. An investor with a five percent return, for example, would see that return cut to two percent in an inflationary environment of three percent. Therefore, an investor needs to consider the effect of inflation when assessing a fund's performance.
• Impact on Bonds: The biggest damage to fixed-income investments from inflation comes in the form of bonds. Theoretically, the investor receiving fixed interest payments from a bond is harmed by inflation, since the interest rate stays the same. If inflation runs at 5% and the person holding the bond gets only 4% interest, there is a negative return - and a loss of purchasing power.
• Increased Interest Rates: Occasionally, when inflation is very high, central banks will increase interest rates. Interest rate has a major influence on lending as increase interest rates raises the cost of borrowing, which can result in reduced consumer spending and business investment. Additionally, the increase in rates declines the present value of the future cash flows, which means they are bringing down the stock market return.
• Stock Market Impact: Inflation affects stocks in a few ways. Certain firms are able to hike rates and transmit costs to customers, but others might have difficulty managing growing expenses. An increased discount rate also increases a stock's present value of future earnings-often lowering a stock's value. During inflationary periods, increased volatility can also lead to more volatility in stocks.

Strategies to Protect a Portfolio Against Inflation

Inflation is powerful, but can be controlled through smart investing There are a lot of things you can do to protect your assets against inflation

• Inflation-Protected Securities: Inflation-Protected SecuritiesTIPS include inflation-adjusted government bonds. If inflation occurs, TIPS' principal will increase, thereby increasing the interest you will pay (as well as the value of the bond when it matures). TIPS are best for conservative investors who want to hedge against the possibility of inflation.
• Gold, oil, and other agricultural products often perform well in inflationary environments. When the price of goods increases, the cost of commodities are likely to follow. Commodities are often seen as the "safe haven" during inflation; while gold is not expected to increase in value during inflation, it has maintained its value during inflation.
• Real Estate Investment: Real estate has historically been one of the most effective inflation hedges. When the cost of living rises, so do property prices and rents. Real Estate Investment Trusts (REITs): Investors can purchase shares in a company that owns, operates, or finances income-producing real estate through a real estate investment trust. Real estate also provides diversification, which reduces risk in an inflationary environment.
• Equity Investments in Certain Sectors: Certain sectors generally do well in an inflationary environment, including energy, consumer staples, and healthcare. These industries can pass through cost increases to consumers without significantly impacting demand for their products. In particular, energy firms benefit from higher commodities prices.
• Diversification: Manage the impact of inflation by investing in multiple assets, sectors and countries have a diversified portfolio. As inflation lowers the buying power of money, diversifying across a wide range of investments can limit the damage inflation does to a single asset class.

Case Study: How inflation can impact bonds and stocks (1970's)

The 1970s is a lesson in what inflation did to investments. One thing about the 1970s, the US had its inflation highs, in excess of 13% in 1979.

This was the result across different asset classes:

Bonds: The real return of government bonds of the 1970s was negative. If inflation were 10 percent or more, a 6 percent U. S. Treasury bond would have been a losing proposition in real terms. You would have received fixed payment streams that shrank in real value, demonstrating the risk of fixed income investments in a high-inflation environment.

Equities: Stock-market investors had a weak decade in the 1970s. Some sectors such as energy thrived in the price-boosting environment of rising commodities prices, but overall markets languished. The average annual return from 1970 to 1980 for the broad S&P 500 was just 5.2 percent, lagging inflation, and U.S. stocks' value deteriorated as inflation increased.

Commodities: Commodities performed well again, especially gold. The price of gold has gone from around $35 per ounce in 1971, at the beginning of the decade, to more than $600 at the end of the decade. Oil also experienced an increase in price, as did many assets investors look to during high inflation periods.

Insights from the Case Study:

• High inflation had a negative impact on both bonds and stocks in the 1970s.
• Commodities (especially gold that acts as a hedge to inflation) gained or increased.
• Real estate, (which was less frequently tracked in those days) has similarly experienced growth during times of rising prices.

Conclusion

How does inflation affect your investment return? As inflation reduces the value of money, it can hit fixed income investments such as bonds particularly hard. Stocks and bonds can take a hit during inflation, although commodities, inflation-protected securities and real estate are the best hedges. A certain degree of diversification in multiple asset classes, sectors and geographies can help to safeguard a portfolio against inflation.

To hedge against the risk of inflation to their investments, investors can build a portfolio with an allocation to assets that tend to perform well when inflation is higher, such as TIPS, commodities or real estate, so you can better protect your savings.

Work Cited

1. “The Impact of Inflation on Asset Prices.” The Balance, 2021, https://www.thebalance.com/impact-of-inflation-on-asset-prices-5199715.
2. “Inflation and Its Impact on Investments.” Investopedia, 2021, https://www.investopedia.com/articles/financial-advisors/071416/inflation-and-its-impact-investments.asp.
3. “Treasury Inflation-Protected Securities (TIPS).” U.S. Department of the Treasury, 2021, https://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm.
4. “Inflation and Investment Returns: A Historical Overview.” Morningstar, 2020, https://www.morningstar.com/articles/1036748/inflation-and-investment-returns-a-historical-overview.