Cruncher is the pseudonym of an actuary working in London with experience in insurance, pensions and investments.
Most of us have heard of inflation. It's a number that turns up on the news every month or so. We have heard that inflation in the economy is a bit like salt in our food: too much is bad for us, but you can also have too little.
But how does it affect our investments? Clearly if inflation can affect the economy, it will affect how your investments perform—just like a hurricane or a oil crisis would.
But inflation can also really hurt your investments directly. And it can hurt some kinds of investment more than others.
This article will explain how inflation can affect your investments and what, if anything, you can do about it.
How Inflation Affects Investment Assets
Inflation means that as time goes on, money is worth less. We say that the value has decreased "in real terms" because the same amount of money will buy less real stuff. Obviously the prices of different things change in different ways over time. For example, smartphones might have got cheaper but salmon fillets doubled in price.
Most of the time when we talk about inflation, we will mean inflation in the whole economy. In most countries, inflation statistics are produced each month measuring inflation in that economy.
However, remember that each of us has a "personal rate of inflation", which is the increase in costs of the things we actually buy. This is likely to be at least slightly different to the inflation rate for the economy as a whole.
So even if your assets were protected against inflation in the general economy, it still doesn't guarantee that it will protect against your personal rate of inflation. But don't worry. Even though there isn't a way that you could sensibly protect against your personal rate of inflation, we can protect against the "narional rate", at least to some extent.
Investment assets eventually pay out in cash in the future. Now if that cash is worth less than you expected in "real terms," i.e. after inflation has taken its toll, then you aren't getting the real return you bargained for. It's no use having more notes in your wallet if those notes will buy you less food in the supermarket.
But some assets go up in value more or less in line with inflation and some don't. Clearly those that do help to protect the real spending power of your investments much better than those that don't.
Shares and Inflation
Remember that owning shares simply means owning part of a business or businesses and getting a share of their profits. If those profits are worthless because of inflation, that obviously hurts your returns.
But over the long term, we would expect the economy to grow faster than the rate of inflation. If the company you own shares with grows at least well as the economy as a whole, then you would expect that, again over the long term, the dividends paid and/or the value of your shares should go up by more than inflation.
Therefore, if you can afford to look at a long time horizon (e.g. more than 10 years) investing in shares can offer you some protection against inflation.
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It's not perfect: it's not guaranteed, and it is not suitable for you if you might need to get this money back quickly to pay your bills, but it is better than some alternatives.
Diversifying Your Investments Can Help
There is no magic bullet in investing, but investing is a diverse range of assets can help to protect you against any single risk wiping you out. Make sure you have some assets in your portfolio that offer some protection against inflation, just in case.
Bonds and Inflation
Remember that bonds are basically just loans to companies or governments. All you can expect to get is your money back together with the agreed rate of interest.
For most bonds (known as conventional bonds), the interest payments are fixed in cash terms. That means that higher-than-expected inflation can be catastrophic for the real value of these bonds. You get back the cash you expected to, but it buys much less. Conventional bonds provide no protection against inflation.
On the other hand, some bonds have interest payments which are linked to an index, usually an inflation index. These are called index-linked bonds. And, assuming they are linked to a relevant inflation index, they provide very good protection against inflation: probably the best protection against inflation you can find. They may have low expected returns, however, because low-risk assets tend to come with low returns.
Property and Inflation
Commercial property is somewhere in between bonds and shares when it comes to the effects of inflation.
Like shares, we would expect the value of commercial property and the rents paid to benefit from growth in the economy. But rent agreements are often fixed over the short or even medium term which may mean that you lose out if inflation erodes the real value of those rent payments.
Sometimes rental agreements include indexation—rents that increase with inflation—in which case rental property would offer you some more protection against inflation, in the same way as index-linked bonds do.
Precious Metals and Inflation
Precious metals are long-lasting assets that can't easily be devalued or disappear. And because of their role as stores of value—gold in particular—they are often popular assets in times of high inflation. And the more people buy into precious metals when inflation is high, the more their price will go up and the better protection it will actually offer against inflation. (It could almost be a self-fulfilling prophecy—if enough people believe it, it will be true.)
However, precious metals in themselves don't generate any wealth in the way that a business does (and investing in bonds, shares or commercial property can get you a share of that generated wealth). Also, their price is often volatile and doesn't provide an exact match for inflation.
Precious metals are probably too unpredictible to be worth putting too much money into. However, they can be useful as "portfolio insurance" that protects you against a complete meltdown in the financial system that would leave most other investments almost worthless.
Protecting Against Inflation
One way to protect your investments against inflation is to make sure you have a decent amount in assets that have some "natural" inflation proofing—like investing in the stock market. This works out on average over the long term, but it doesn't protect you from every possible market shock.
However, this is not perfect protection. And you need to be aware of the opportunity cost: by choosing not to invest in assets which have a big inflation risk, you will probably be giving up some expected investment returns. Because reduced risk usually comes with reduced return.
Alternatively, you could explicitly protect your portfolio against inflation by taking out a "swap" contract that would pay you money if inflation is high (but where you pay money back if it is low). This will remove some or all of the inflation risk from your investment portfolio.
Explicitly protecting your portolio against inflation has the advantage that you can then invest in a diverse mix of assets without worrying how inflation could damage their value.
But again, like an insurance policy, this will cost you money. And because this kind of swap is still not a very mainstream product it's likely to be expensive unless you want to insure a large amount. However, this should change as and when this kind of product becomes more popular.
Investing is always uncertain. Nothing is guaranteed. None of us can protect ourselves completely against inflation on our own.
Besides if you want to get the rewards of investing you have to be prepared to take risks.
The best thing you can be is forewarned against potential risks—and understand them. That way you can position your portfolio so that you are partially protected against high inflation. The important thing is to understand the risks you are taking with your money and be happy that you are getting the return to compensate you for them. Understanding the effect of inflation on your investment assets will help you get that control.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.