Inflation implies to a broad and sustained rise in the prices of services and products used by people on a regular basis. Its impact is commonly viewed through the lens of the household budget. However, according to Kavan Choksi, inflation also does impact the functioning of investment portfolios to a good extent. A mild level of inflation can be healthy for an economy and the financial markets. On the other hand, rapidly rising inflation may have a negative impact on both stock and bond investments.
Kavan Choksi underlines the impact of inflation on investments
To properly understand how inflation can eat away the investment returns of an investor, it firstly becomes vital to differentiate between nominal and real interest rates. The former is the rate of interest without any adjustment for inflation, while the latter is the nominal interest rate minus the rate of inflation. The real interest rates account for inflation, and show the actual gain or loss in the purchasing power. For investors to earn a real return, nominal interest rates should keep up with or outpace inflation.
Cash and cash equivalents typically receive the biggest blow in the times of inflation. In case there is no interest being generated to compete with the rate of inflation, it might eventually eat into the purchasing power of the cash. Inflation can even shrink the savings of a person if they have secured their funds in a savings account with an average interest rate. In theory, when a person is working, their earnings should ideally keep pace with inflation. However, if one is living off their savings, inflation may diminish their buying power. As a result, people must monitor their savings against inflation with care so that they have enough assets to last through the retirement years.
Inflation can considerably reduce real returns on fixed income investments like treasuries, municipal bonds and so on. Ideally, investors purchase fixed income securities to enjoy a stable income stream in the form of interest payments. But as the income stream remains the same on the majority of fixed income securities until maturity, the purchasing power of the interest payments tends to decline as inflation goes up. As a result, bond prices fall when inflation is increasing. One must also know that value stocks tend to perform better than growth stocks when inflation is high.
As per Kavan Choksi, on the whole, inflation can have a major impact on the investment portfolio of a person over time. Hence, to protect the investments against inflation, one must take steps to diversify their portfolio with exposure to U.S. stocks and real assets. While inflation might be beyond the control of a person, they can always take action to help preserve their investments and savings from its impact. Investing in Treasury Inflation-Protected Securities (TIPS), for instance, would be a good idea to keep money protected in the times of inflation. The rate of return on TIPS is adjusted in accordance with the CPI. This can result in a more reliable performance than most of the other types of bonds and asset classes.