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 Rs. 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.
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 Rs.100. At an inflation rate of 3 percent, the principal value will come down to Rs.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: There type of 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.
- – Floating interest rate products: In these products, the rate of coupon payment increases or falls with the changing interest rates. The central bank usually uses the interest ratesas 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
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.