Most people understand that inflation increases the price of their groceries or decreases the value of the dollar in their wallet. In reality, though, inflation affects all areas of the economy — and over time, it can take a bite out of your investment returns.
What is inflation?
Inflation is a rise in the average cost of goods and services over time. Consider the price of a loaf of bread 10 years ago. Over the last decade, the price of that bread has certainly increased.
But inflation isn’t measured by tracking the price of one item. Instead, it’s measured by the Bureau of Labor Statistics, which compiles data to determine the Consumer Price Index (CPI). The CPI tracks the cost of goods such as gasoline, food, clothing and automobiles over time to gauge the overall rise in the price of consumer goods and services.
In January 2020, for instance, the CPI was 2.3.1 That means overall prices increased by 2.3 percent over the last 12 months. In theory, this means a car that cost $20,000 in 2019 would cost $20,460 in 2020.
Another way to view the effect of inflation is the impact on purchasing power, which is a measure of the amount of goods and services a consumer could purchase with a specific sum of money. In 2019, $20,000 could have purchased the car from the above example – but in 2020, $20,000 does not have that same buying power.
Relationship between inflation and interest rates
To understand how inflation can eat away at your investment returns, it’s important to differentiate between nominal and real interest rates.
- The nominal interest rate is the rate of interest without any adjustment for inflation. You would earn this interest rate only if inflation was zero.
- The real interest rate is the nominal interest rate minus the rate of inflation. This interest rate accounts for inflation, showing your actual gain or loss in purchasing power.
Nominal interest rates must keep up with or outpace inflation for an investor to earn a real return. This means investments with lower interest rates are hit harder by the effects of inflation. Cash and cash equivalents receive the biggest blow of all. When there’s no interest being generated to compete with the rate of inflation, it can quickly eat into the purchasing power of your cash.
How can inflation affect investments?
Here’s a look at how inflation could affect your various investments.
- Savings. Inflation can shrink your savings even if you’ve secured your funds in a savings account with an average interest rate. In theory, when you’re working, your earnings should keep pace with inflation. When you’re living off your savings, as in retirement, inflation diminishes your buying power. It’s important to ensure you have enough assets to last through your retirement years.
- Fixed income investments. Inflation can significantly reduce real returns on fixed income investments such as bonds, treasuries, and CDs. Typically, investors buy fixed income securities because they want a stable income stream in the form of interest payments. However, since the rate of interest remains the same on most fixed income securities until maturity, the purchasing power of the interest payments declines as inflation rises.
- Stock investments. Historically, stocks have held up well against inflation. In theory, a company’s revenues and earnings should increase at a similar pace as inflation. This means the price of your stock should rise along with the general prices of consumer and producer goods.
How to defend your portfolio against inflation
Inflation’s impact on investments can be subtle. Alongside working with a financial professional, consider two steps that may help protect your investments against inflation:
- Diversifying your portfolio with a mix of stocks, bonds, and atypical assets, such as commodities and real estate investment trusts (REITs), can help you shield your money against inflation. However, diversification and asset allocation do not protect against losses or guarantee returns.
- Consider inflation-protected securities (IPS). The rate of return on an IPS is adjusted for inflation to guarantee a real return in the end. Popular IPS options include Treasury inflation-protected securities (TIPS) from the U.S. federal government and corporate inflation-protected securities (CIPS) from private sector companies.
Inflation might be beyond your control, but that doesn’t mean you can’t take actions to help preserve your investments and savings from its effects.
Learn how interest rates affect investments.
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. There are special risks associated with investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in the interest rates and risks related to renting properties (such as rental defaults).