Effect of Inflation on Investment

Inflation reduces the value of your money; it is the phenomenon of too much money chasing a few goods. As prices of products and services rise in an economy, it reduces the consumers’ power to buy. In other words, the number of things you could buy for ₹100 a few years back will now fetch you much less, due to inflation. This also plays out on your savings. When we save for the future, what we mainly want is to have more disposable income or purchasing power in the long term. But if our investments are not inflation adjusted, then inflation can eat into our savings. We might find the returns do not keep pace with the price of goods in the future.

What Is Inflation?

Inflation refers to the gradual decline in the purchasing power of money, reflected in a steady increase in the prices of goods and services over time. It is measured by calculating the average price rise of a selected group of goods and services over a year.

• High inflation indicates a rapid increase in prices, reducing the value of money.
• Low inflation means prices are rising at a slower rate, allowing money to retain more of its value.
• Deflation, on the other hand, occurs when prices fall, increasing purchasing power.

The primary cause of inflation is an increase in the money supply, which can occur through various means, such as:

• Printing and distributing more money within the economy.
• Reducing the value of the national currency through devaluation.
• Expanding the money supply by issuing new loans or purchasing government bonds.

Inflation is a crucial economic factor, influencing consumer purchasing power, investment decisions, and overall economic stability.

The impact of inflation on Investments

• Impact on equities: Moderate inflation can drive economic growth, leading to higher corporate revenues and stock prices. However, excessive inflation raises production costs, reduces profit margins, and weakens consumer demand, resulting in declining stock values.
• Impact on fixed-income investments: Bonds and fixed deposits offer fixed returns, making them vulnerable to inflation. When inflation surpasses interest rates, the real value of returns diminishes. Inflation-indexed bonds help mitigate this risk by adjusting their principal value in line with inflation.
• Impact on alternative assets: Real estate and commodities often act as inflation hedges. Property values and rental income typically increase during inflationary periods, preserving real returns. Gold, a traditional store of value, also appreciates as investors seek stability.
• Impact on international investments: Inflation varies across economies, making global investments a useful diversification tool. A thriving foreign market with lower inflation can provide better returns, offsetting losses in a high-inflation domestic economy. However, currency fluctuations and geopolitical risks must be considered.
• Portfolio diversification against inflation: A well-balanced portfolio incorporating equities, inflation-resistant assets, and international investments can help mitigate inflation risks. Regular market assessment and strategy adjustments are essential for maintaining purchasing power and long-term financial growth.

What Causes Inflation?

Inflation arises due to multiple economic factors that influence the prices of goods and services. Understanding these causes can help individuals and businesses make informed financial decisions.

• Rising production costs: When the cost of raw materials, wages, or transportation increases, businesses pass these expenses onto consumers through higher prices. Supply chain disruptions can further amplify production costs, contributing to inflation.
• Increased consumer demand: When demand for goods and services outpaces supply, prices naturally rise. This often occurs during periods of strong economic growth, where higher wages and greater consumer confidence drive spending.
• Monetary and fiscal policies: Government policies, such as tax cuts or increased public spending, can inject more money into the economy, leading to inflation. Similarly, lower interest rates encourage borrowing and spending, further increasing demand-driven inflation.
• Currency depreciation: A weaker currency makes imported goods more expensive, raising overall price levels in an economy. Countries that rely on imports for essential commodities, such as fuel or food, are particularly susceptible to this type of inflation.
• Global economic factors: External events, such as geopolitical tensions, trade restrictions, or energy price fluctuations, can disrupt markets and drive inflation worldwide. For instance, a surge in oil prices can increase transportation and production costs across industries.

While inflation is a natural part of economic cycles, excessive inflation can erode purchasing power and create financial instability. Central banks closely monitor inflation and adjust monetary policies to maintain economic balance.

How Does Inflation Affect Investment?

The effect of inflation on investment is two-pronged. One, it eats into your savings, and second, inflation reduces your real returns on investment if the returns are not adjusted for price rise.

For example, if an investment gives you 2 per cent returns and the rate of inflation is 3 percent when your investment matures. Your profits will be negative (-1 per cent), taking the cost of inflation into account.

Many risk-averse investors prefer the safety of fixed income instruments. Such assets give you a steady flow of income in the long term and are comparatively less affected by volatility. But inflation, however, may affect returns on fixed-income investments.

That is because; the rate of interest you are going to receive on maturity is fixed, while prices of goods or inflation may be much higher than the rate of returns. In other words, your real returns would be less than the rate of interest offered by the instrument on maturity. Not just the interest payments, inflation also reduces the actual value of the principal sum you have invested in fixed income.

For example, you bought a five-year government bond for a face value of ₹100. At an inflation rate of 3 percent, the principal value will come down to ₹83 when the bond matures.

Nominal Interest Rate and Real Interest Rate

For any fixed-income investment like bonds and debentures, annuities, treasury bills or commercial papers, there is a nominal interest rate and the real interest rate. The nominal interest rate indicates the inflation expectation of the markets. An increase in nominal interest rates marks an expectation that inflation is likely to rise further. Falling nominal interest rates mean that prices of goods and services are likely to drop.

The nominal interest rate is the gross interest rate you will receive without adjusting for the price rise or inflation. The nominal interest rate does not tell you anything about your real returns. In other words, this is the rate of interest you will receive if the inflation was zero percent.

The real interest rate is the nominal interest rate less the rate of inflation. It reflects the real purchasing power of the money you are going to receive on maturity.

Can Inflation Be Suitable for Your Investment Portfolio?

Inflation is a double-edged sword for some asset classes. Yes, some asset classes may benefit from inflation because the asset prices also rise as inflation climbs. But hyperinflation in an economy is a sign that the economy is overheating. This can be worrying as it will affect consumer demand. Decreasing consumer demand and spend will factor in the forecasts of company earnings, affecting their stock value.

• When inflation is high, stock investments are seen as a favourable investment option. This is because widespread price rise also means companies will increase prices of their goods. Higher rates can translate to better earning potential, especially if the demand for a product is inelastic. But,for the reasons given above, lower consumer demand and lower earnings forecast-inflation can also affect stock prices negatively in the short term.
• Commodity prices also rise with inflation, especially commodity derivatives.

To Protect Your Portfolio Against Inflation

Today, there are many investment options available that give you inflation-adjusted returns.

• Inflation-indexed securities are mostly bonds issued by companies and the government. The principal for these bonds is indexed to inflation. These products give you returns higher than the rate of inflation. Inflation-indexed products protect your returns from the effect of inflation.
• In floating interest rate products the rate of coupon payment increases or falls with the changing interest rates. The central bank usually uses the interest rates as a tool to tame in inflation by increasing or tightening lending rates. Interest rates are inversely proportional to bond prices. When interest rates rise, bond prices fall and vice versa.
• Certain commodity prices are also a good hedge against inflation as these prices rise along with inflation.
• Some experts also suggest investing in equity income funds. These funds invest in companies that give you income in the form of dividends

Conclusion

If your investment strategy does not take into account the impact of inflation on investment, then expensive securities may eat into your returns. In other words, the money you save for the future may not be enough to beat the rising price of goods and services. But there are ways around it.

There are inflation-indexed products that give you adjusted returns, where real yields are higher than the inflation rate. Also, there are assets whose prices move with inflation, and so their yields are higher when there is a widespread price increase.

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