Assume that a hamburger costs $2 this year and that inflation is 10% annually. Theoretically, 10% inflation means that the same hamburger will cost $2.20 more the following year. Therefore, if your income rises at least as quickly as inflation, you will be able to purchase fewer hamburgers.
However, a temporary increase in the price level brought on by the rise in the price of oil or the implementation of a new sales tax is not true inflation unless it results in a wage-price spiral as wages and other costs rise. Similarly, an increase in just one product's price does not necessarily indicate inflation; instead, it may simply represent a change in the relative price that reflects a decline in the product's availability.
Inflation results from the rise in the amount of money in circulation relative to the level of economic output. Price increases as there are more funds to pursue fewer things. This phenomenon is also known as the fall in the purchasing power of a currency.
Investors should endeavour to purchase investment products with returns at least as high as inflation while keeping this concept in mind. For instance, if inflation was 5% and ABC stock returned 4%, the real return on investment would be -1% (5% - 4%).
How Does Inflation Work?
Numerous things might cause costs to increase steadily. Inflation is often divided into two basic categories by economists:
- Demand-Pull Inflation—When a product's supply is constrained, and demand is high, the price of that product will typically increase. This occurs because consumers are willing to pay extra for that product and because its creators know they can do so.
- Cost-Push Inflation—The rising cost of conducting business in this situation—increases in labour or raw materials, for example—means that companies must pass along price increases to their customers to remain successful.
How Does Inflation Affect Investors?
Liquid assets are affected by inflation just like any other asset, except that they typically increase less in value over time. As a result, liquid assets are generally more susceptible to the damaging effects of inflation. In terms of the overall economy, people and corporations typically keep fewer liquid assets when inflation increases.
Illiquid assets are likewise impacted by inflation, but if they increase in value or produce interest, they have built-in protection. Most investors invest in stocks, bonds, and mutual funds primarily to protect their savings from the consequences of inflation. When inflation is sufficiently strong, people frequently invest their liquid assets in assets that pay interest or use the liquid assets to buy products.
Therefore, you may safeguard your buying power and investment returns by investing in a variety of inflation-protected securities, such as inflation-indexed bonds or Treasury inflation-protected securities. These assets are resistant to inflation risk because they fluctuate with inflation.
Safeguard Your Investment During Inflation?
As an investor you must know how to hedge against inflation since it can impact your portfolio's performance. You can hedge your bets even though you might need help to prevent inflationary pressures. Consider boosting your portfolio with gold, which has long been seen as an inflation hedge. diversify your portfolio by using index funds, real estate-based assets, and a variety of asset classes.
Other Ways to Protect Your Portfolio Against Inflation
There are numerous investment options available today that provide returns that are adjusted for inflation.
- Inflation-Indexed Securities: Most of these securities are government and corporate bonds. These bonds' principal is linked to inflation. You get returns from these goods that are more than the rate of inflation. Products that are inflation-indexed shield your earnings from the impact of inflation.
- Floating Interest Rate Products: These products' coupon payment rates fluctuate with changing interest rates, rising or falling. The central bank uses lending rates—either to control inflation. Bond prices decline as interest rates rise.
- Given that they rise in tandem with inflation, many commodity prices also serve as good hedges against inflation.
- Equity income funds are another investment option, some experts advise. These funds make investments in businesses that pay dividends to investors.
The general tendency of rising costs over a specific period is what inflation is. The purchasing power of money declines with inflation, meaning that less of the same commodity or service can be purchased for the same amount.
For investors, the returns on their assets must grow at least as quickly as inflation; otherwise, even though they show gains, their investments are losing money. Similarly, people must make sure that their pay increases annually by an amount equal to the rate of inflation. Otherwise, they are earning less.