What Could Inflation Mean for Your Investments
How does inflation affect your investments over time? Here’s a look at how inflation works and what investors need to know.
The average investor doesn’t tend to think about inflation, especially not in times of good economic health. Plus, it’s hard to notice inflation in the moment for the same reason you can’t see the entirety of New York City while standing in Times Square.
But remember, inflation is a decrease in purchasing power over time. That’s a big deal for your investments, since it means your money may not get you as far in five years as it does right now.
What does inflation mean for your investments? Here’s a look at how inflation can affect your investment assets and what you can do to protect your money.
What is Inflation?
Inflation is simply the decline of a currency’s purchasing power over time. This is expressed as a percentage rate of decline, which is calculated by looking at the average prices of a basket of selected goods and services in the economy over time. Because prices go up, a single unit of currency buys less than it did before.
It’s sometimes classified into three categories:
- Built-in inflation
- Demand-pull inflation
- Cost-push inflation
The most common is demand-pull inflation, when the aggregate demand for a good or service outstrips supply.
Inflation can be positive or negative depending on your perspective. For someone with tangible assets, for example, inflation can be a good thing—it means the value of their asset goes up.
How It’s Measured
It’s easy enough to chart the rise in prices of a single good or service over time. But as humans, we need more than one or two goods to get by in life. Inflation is not the measure of a small handful of prices, but rather a measurement of the overall impact of price changes on a diversified set of products and services.
In plain English? These are price increases you see across an entire sector.
Inflation is expressed as the inflation rate, the percentage increase in a specified set of goods or services during a defined period (usually a month or a year). This percentage tells you how quickly prices rose during that period. In the U.S., it’s measured using the Consumer Price Index, the Producer Price Index, and the Personal Consumption Expenditures Index.
Central banks use monetary policy to keep inflation and its inverse, deflation, in check for an overall healthy economy. That’s because inflation and unemployment are part of the misery index, which charts the average citizen’s financial health. The goal is to reach the right meeting place of maximum employment and price stability, meaning that individuals and businesses may reasonably expect prices to be low and stable while still being able to make sound saving, borrowing, and investing decisions.
To this end, the U.S. Federal Reserve generally aims for an inflation rate of 2% year-over-year.
This is a tricky balance to strike. If inflation runs below its desired level, people come to expect it, which means they can push actual inflation even lower. This would drag down interest rates too, which would leave less available space to cut interest rates and boost employment during an economic downturn.
Effects of Inflation on Your Investments
So, what does inflation mean for your investments? Well, it’s complicated, but it depends on your perspective.
Broadly speaking, inflation tells investors in percentage terms what their investments need to earn in order to maintain (or improve) their standard of living. The idea in investing, generally speaking, is to buy investment assets with returns greater than or equal to inflation.
Inflation and Asset Classes
The easiest way to think about this is to look at how inflation affects asset classes. To do this, think of investments in two basic categories: liquid and illiquid.
A liquid asset refers to either cash on hand or an asset that can be quickly converted into cash if necessary. Stocks are a great example of liquid assets. Inflation has the same overall effect on liquid assets as any other asset with one key difference: liquid assets tend to appreciate over time. In plain English, this means liquid assets are more vulnerable to inflation over time, and individuals and businesses hold fewer liquid assets in times of significant inflation.
An illiquid asset, on the other hand, is an asset that cannot be converted into cash easily. The most common example is a piece of real estate, since it takes months to see the value of a sale appear in cash. These assets are also affected by inflation, but they have a defense against it if they generate interest or appreciate.
How to Protect Your Money
In general, the most powerful way to protect yourself against inflation is to earn more money. But if that’s not on the table, you’ll need to get creative.
For investors, that means diversifying across several different inflation-resistant asset classes. For example, that can mean equity investments like REITs and inflation-resistant fixed income investments. Stocks tend to keep pace with inflation (better than bonds) but they’re also volatile, so it’s a good idea to hedge additional inflation protection against the stock market, namely with alternative investments that have a low correlation to stock market performance and hold intrinsic value regardless of the larger economy.
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