Understanding Inflation and its Impact on Investment

 

Money loses value due to inflation, which is caused by too much money going after too few products. In an economy, consumers' purchasing power decreases when goods and services become more expensive.  An ongoing, broad ability of rising costs from year to year is called inflation. 

The inflation rate measures how quickly prices rise over time and how quickly investments lose their actual value. Also, investors can use inflation to determine the exact % return on their investments that will preserve their level of living.

Essential Notes

1. The inflation rate measures how quickly prices rise over time and how quickly investments lose their actual value.

2. Inflation also shows the required rate of return on investments for maintaining a given level of living.

3. When the amount of money in circulation rises in comparison to the quantity of productive production in the economy, inflation results.

4. One product price increase may just be a relative price change reflecting shifts in supply or demand rather than inflation in and of itself.

Understanding Inflation

An example is the simplest way to describe inflation. Consider that this year, the annual inflation rate is 10% and you can get a hamburger for $2. In general, a 10% inflation rate would mean that the same burger would cost $2.20 more the following year.

You will not be able to purchase as many burgers if your income doesn't increase at least at the rate of inflation. On the other hand, a one-time increase in prices brought on by a rise in the price of oil or the implementation of a new sales tax isn't considered true inflation until it results in a wage-price spiral that drives up other costs and wages.

Similarly, an increase in the cost of a single good is not always a sign of inflation; rather, it can be the result of a relative price shift caused by a reduction in the product's availability. The main cause of inflation is the increase of money, which results from having too much money and seeking too few goods.

What causes Inflation?

When the supply of products and services cannot keep up with the demand, inflation is the main result. Price increases result from this, which is referred to as inflation based on demand-pull. The rise in the cost of producing products and services also contributes to inflation. 

Producers raise the selling price of their goods to make or keep a profit when the cost of production rises. We call this inflation driven by costs.

How does Inflation affect Investment?

Inflation has a dual impact on investments. Inflation reduces your actual returns on investment if the returns are not adjusted for price increases, and it also eats away at your savings.

Suppose, for example, that an investment generates 2% returns and that, when it matures, inflation will be 3%. Including the effect of inflation, your profits will be negative (-1) percent.

The security of fixed-income securities is preferred by many investors who do not like risk. These assets are somewhat more stable and provide you with a consistent stream of income over time. On the other hand, inflation might have an impact on fixed-income investment returns.

This is because, while the rate of return on your investment is fixed, the prices of goods or inflation may be significantly greater. Put differently, your actual returns would be lower than the interest rate that the instrument offers when it matures.

Inflation lowers the real value of the principal amount you invested in fixed income in addition to interest payments. As an example, let's say you invested Rs. 100 in a government bond with a five-year maturity period. When the bond matures, the principal value will decrease to Rs. 83 at a 3% annual inflation rate.

Nominal Interest Rate and Real Interest Rate

There are nominal and real interest rates for every fixed-income investment, such as bonds, debentures, pensions, government securities, and commercial papers. The markets' expectation of inflation is reflected in the nominal interest rate. 

An increase in nominal interest rates indicates the possibility of future inflation increases. There will probably be a decrease in the price of goods and services when nominal interest rates decline.

The gross interest rate you will get without accounting for inflation or price increases is known as the nominal interest rate. You cannot infer anything about your actual returns from the nominal interest rate. Put differently, this represents the interest rate you would get if there was no inflation.

The real interest rate is the nominal interest rate less the rate of inflation. It shows you how much money you will be able to buy when the funds mature.

Can Inflation be suitable for your Investment Portfolio?

There are two sides to inflation for different asset types. Yes, as asset prices rise in parallel with inflation, certain asset classes may gain from it. Given that it will impact consumer demand, this may be concerning. The stock value of companies will be impacted by decreasing customer demand and spending, which will impact the company's earnings estimates.

1) Investing in stocks is considered a favorable alternative when inflation is high. This is because general price increases also indicate higher pricing for items from businesses. Greater earning potential may result from higher rates, particularly in cases when product demand is not flexible. 

However, for the reasons mentioned above, decreased demand from consumers and a decline in profitability projections can also affect stock prices negatively in a short time.

2) Prices for commodities, particularly commodity derivatives, increase in line with inflation.

To protect your portfolio against Inflation

You can find a lot of investing options that provide returns that are adjusted for inflation nowadays.

1. Securities Inflation-Indexed: These securities are mostly bonds issued by corporations and governments. These bonds have inflation-indexed principles. Your returns from these products exceed the rate of inflation. Inflation-indexed products protect your returns from the impact of rising costs.

2. Products with floating interest rates: In these products, the rate at which coupons are paid rises or falls in line with fluctuations in interest rates.  Normally, the central bank controls interest rates to modify lending rates to restrain inflation. Interest rates and bond prices are oppositely related. Bond prices decrease when interest rates rise and vice versa.

3. Since some commodity prices rise in combination with inflation, they are also a great protection against inflation.

4. Also, some experts advise purchasing equity income funds. These funds make investments in businesses that provide dividends to you.

Conclusion

Investing in expensive assets can reduce your returns if your approach does not account for how inflation affects investments. The general pattern of price increases over a given period is referred to as inflation. When buying power declines due to inflation, more money must be spent to obtain the same commodity or service, or less money can be used to purchase the same goods and services. 

Returns on investments for investors need to be at least as high as the rate of inflation. If not, even if the value of their investments increases, they are losing money. In a similar vein, people should make sure their pay increases in line with inflation as failing to do so will reduce their purchasing power.