How inflation affects investments
Guide Summary
- Inflation reduces the real value of investment returns and can affect different asset classes in distinct ways.
- Stocks and commodities can offer some protection, whilst bonds, especially fixed-rate, may be impacted due to historically steadier returns.
- A diversified, inflation-aware portfolio can help mitigate the long-term risks to your purchasing power.
What is inflation?
Inflation is the rate at which prices for goods and services rise over time, reducing the purchasing power of your pounds.
For example; if the inflation rate is 5% per year, something that costs £100 today, will cost £105 in a year. If your savings or investments return 3% during that time, you’ve effectively lost money in real terms, even if your balance is showing a positive return.
What causes inflation?
Inflation doesn’t usually have just one cause, and it’s often the result of several factors working together. Some of the main things that can drive prices up include:
- Demand-pull inflation: When demand for goods and services exceeds supply, prices can rise.
- Cost-push inflation: When production costs (like wages or raw materials) increase, businesses may pass these onto consumers.
- Built-in inflation: When workers expect prices to rise, they may demand higher wages, which can lead to higher prices, creating a feedback loop.
- Monetary policy: When central banks increase the money supply, too much money chasing too few goods can drive up prices.
Why is inflation bad?
While low and predictable inflation is generally considered a sign of a healthy economy, high or unpredictable inflation can cause various economic problems such as:
- Erosion of purchasing power: Your money buys less over time.
- Distorted investment returns: A 4% return in a 5% inflation environment is effectively a loss.
- Increased uncertainty: Investors and businesses may hesitate to make decisions when future costs and prices are unclear.
- Impacts fixed income assets: Pensioners or bondholders with fixed payouts see their real income decline.
How inflation can affect investments
Inflation can reduce the real (after-inflation) return on investments. If your investment portfolio grows at 4% in a year, but inflation is at 6% in the same period, your returns have effectively shrunk by 2%.
Some further effects of inflation include:
- Influence on investor behaviour, encouraging shifts toward inflation-resistant assets.
- Central banks may raise interest rates to combat inflation, which can affect asset prices and market sentiment.
The impact inflation can have on different investment assets
Many investors choose to build a balanced investment portfolio that contains different asset classes. Inflation can have various effects on these asset classes:
How inflation can affect stocks
- Inflation can reduce company profits if costs rise and firms can’t pass them on to consumers.
- Various sectors and industries have historically performed better during inflationary periods whilst some have performed worse.
- Long-term, equities tend to outpace inflation, but short-term volatility can increase.
- Learn what stocks are.
How inflation can affect ETFs
- The impact depends on the ETF’s underlying assets.
- Equity ETFs in inflation-sensitive sectors may offer some protection.
- Bond ETFs may underperform if interest rates rise in response to inflation.
- Learn what ETFs are.
How inflation can affect bonds
- Fixed-rate bonds lose value when inflation rises, as their interest payments become less attractive.
- Inflation-linked bonds adjust payouts with inflation and can offer protection.
- Learn what bonds are.
How inflation can affect commodities
- Often seen as a hedge against inflation, especially gold, oil and agriculture.
- Prices for physical goods tend to rise with inflation, making commodity investments more attractive during such periods.
- Learn what commodities are.
How to protect your investments from inflation
While inflation can’t be avoided, investors can take steps to mitigate its effects and attempt to protect their investment portfolio value. This can involve:
- Diversification across asset classes with different sensitivities to inflation.
- Focusing on real returns, not just nominal growth (pre-adjusted figure).
- Stay focused on the long-term. Market cycles often balance out inflation over time.
Inflation and investments summary
Inflation can quietly erode the value of money and investments if not properly understood and managed.
By recognising how it impacts different assets and taking a thoughtful, diversified approach, investors can better preserve their wealth in real terms.
Next in our economic context series, is understanding interest rates and the stock market. Understand how central bank rate decisions can impact financial markets and what it means for investors.
When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than your original investment. Chip does not offer financial advice and this should not be considered as a personal recommendation. Diversifying means spreading your investments across different sectors, countries and asset classes.
