Investing Long Term? Don't Overlook Inflation
We have all heard the old adage, “Money doesn’t grow on trees.” Perhaps it would in the perfect world, but as it stands, one of the certified means to grow money is through investments.
Investment has been established as a key factor in the accumulation of wealth which will help in the achievement of financial freedom in the years ahead.
When investing for long-term goals, it is important to consider the effects of inflation on your investment returns. Over time, inflation can erode the value of an investment as a moderate inflation rate today can have a large impact on the purchasing power of your money over 20 or 30 years.
This is especially true in today’s COVID-impacted environment where around the globe, governments launched stimulus packages over unprecedented amounts in the wake of the pandemic, causing a dramatic increase in public debt.
This has raised the question of how the high volumes of debt can ever be repaid in the future. Through economic growth? Budget surpluses? Or will the debt be inflated away? Experts have purported that it is not certain that the coronavirus crisis will lead to higher inflation in the long term. Nevertheless, it may be worthwhile for investors to take a detailed look at the potential implications of rising inflation.
One may ask; what is inflation? Inflation is defined as the increase in prices of goods and services, usually occurring over the course of a year. It is generally associated with a loss of the purchasing power of money: After a year, people can buy fewer goods for the same amount of money in visual terms.
A poor harvest increases food prices– as there are fewer goods available for money to chase. However, in addition to supply and demand changes, other factors may be responsible for rising inflation, such as government borrowing and a subsequent money supply expansion facilitated by the central bank, which then devalues the money held in physical cash or bank deposits.
A nation's monetary authority such as a Central Bank, will work to keep the rate of inflation within a margin that keeps the economy running and encourages growth. Some level of inflation is necessary as it promotes spending which helps national economic growth. In most countries, the Statistical Office publishes the inflation rate every month
The opposite of inflation is deflation, which represents a sustained decline in the level of prices for goods and services. Here, the main risk is that both consumers and companies would have an incentive to put aside their increasingly valuable money and postpone purchases and investments over and over again. This would trigger an economic downward spiral.
Risks associated with inflation
Inflation reduces the purchasing power of money: For example, if an employee always receives the same salary for a period of time, he or she can afford less and less because of rising prices.
Inflation is one reason many people don't put all their money in the bank. As one saves and invests, it is paramount to keep an eye on inflation trends. If inflation rises, savings and assets shrink in real terms. Capital invested at a lower rate of return than the inflation rate steadily loses purchasing power. For this reason, investors need to make sure that the interest rate or yield on their investments is above the inflation rate.
Inflation Affects Savings
Inflation has a negative impact on savings and shrinks them with time. For instance, if you have ₵100 in your savings account that pays an interest rate of 1%, you will have ₵101 at the end of the year. However, if the inflation rate is more than the interest rate, at say 2%, you will require ₵102 to have the same buying power as at the beginning of the year. Thus, you will effectively lose money if your savings do not grow at the same rate as inflation.
This situation has become even more critical in the current times with record-low interest rates. At the current rate of interest paid to the savers, the money saved and interest earned will not be enough to balance the loss in value of money caused by inflation.
How Inflation Impacts Investments
The impact of inflation on investments depend on the investment types. For investments with a set annual return, like regular bonds or bank certificates of deposit, inflation can hurt performance, since you earn the same interest payment each year, it can cut into your earnings. If you receive a payment of ₵100 per year, for instance, that payment would be worth less and less each year given inflation.
For stocks, inflation can have a mixed impact. Inflation is typically high when the economy is strong. Companies may be selling more, which could help their share price. However, companies will also pay more for wages and raw materials, which hurts their value. Whether inflation will help or upset a stock can depend on the performance of the company behind it.
On the other hand, precious metals like gold historically do well when inflation is high. As the value of the dollar goes down, it costs more dollars to buy the same amount of gold.
Finally, there are some investments that are indexed for inflation risk. They earn more when inflation goes up and less when inflation goes down, so your total earnings are more stable. Some bonds and annuities offer this feature for an additional cost.
Protecting yourself against inflation
As established above, over time, that inflation can erode the value of those savings. For that reason, some prefer to keep some of their money in potentially higher-growth investments like stocks or mutual funds, because on average these investments earn more per year than the inflation rate
Investors can reduce their exposure to inflation risk using a variety of methods. The most popular method to hedge against inflation is by purchasing hard assets, including gold, oil, farmland, natural gas or, to a higher degree, real estate. In general, these assets tend to be negatively correlated with both stocks and bonds.
Real assets can usually provide protection against inflation. These include Commodities like gold, Real Estate and Equities.
In addition, investors could take advantage of inflation-indexed bonds, in which the nominal value and/or the coupon are linked to consumer price trends. If inflation rises, for example, the coupon payment due on these securities increases accordingly.
Owning your home is perceived as a value in this situation because residential real estate prices tend to move in the same direction as inflation.
It is a popular choice not only because rising prices increase the resale value of the property over time, but because real estate can also be used to generate rental income. Just as the value of the property rises with inflation, the amount tenants pay in rent can increase over time.
These increases let the owner generate income through an investment property and helps them keep pace with the general rise in prices across the economy.
When a currency is having problems— as it does when inflation climbs and decreases its buying power— investors turn to commodities.
For centuries, the leading commodity has been gold— and, to a lesser extent, other precious metals. Gold has been considered a store of value by mankind for thousands of years, which is one of the reasons why it was minted into coins in earlier times.
Investors tend to go for the gold during inflationary times, causing its price to rise on global markets.
Gold can also be purchased directly or indirectly. You can put a box of bullion or coins under your bed if you favour a direct purchase, or you can invest in the stock of a company involved in the gold mining business. You can also opt to invest in a mutual fund or exchange traded fund (ETF) that specializes in gold.
Commodities also include items like oil, cotton, soybeans, and orange juice. Like gold, the price of oil moves with inflation. This cost increase flows through to the price of gasoline and then to the price of every consumer good transported by or produced. Agricultural produce and raw materials are affected as well as automobiles. Since, as it stands, society cannot function without fuel to move vehicles, oil has a strong appeal to investors when prices are rising.
Equities are real assets as well. They represent ownership interests in a company, which in turn owns other real assets– and shareholders therefore own a small part of these assets. These could be administrative buildings or machinery, for instance. Thus, it is quite common to see share prices rise on the equity markets when inflation rates pick up.
Leveraged loans are potential inflation hedges as well. They are a floating-rate instrument, meaning the banks or other lenders can raise the interest rate charged so that the return on investment (ROI) keeps pace with inflation.
Mortgage-backed securities (MBS) and collateralized debt obligations (CDOs), which are structured pools of mortgages and consumer loans respectively, are also an option. Investors do not own the debts themselves but invest in securities whose underlying assets are the loans.