Inflation has been fairly tame over the last few decades, but it’s now becoming top of mind for consumers and investors, as it has increased significantly in the recent past. In 2021, Canadian inflation averaged 3.4%, the highest annual rate since 1991, while the rate in February of 2022 was even higher, at 5.7%.
Inflation causes a loss of purchasing power for consumers—as prices rise, a dollar (or euro, or yen, etc.) can’t buy as much as it did the previous year. For consumers, it’s easy to see the effects of inflation on wallets, since prices increases are easily noticed—particularly for items that can change rapidly, such as food and gas.
Rising prices, particularly when they start to rise rapidly, can also be detrimental to investment portfolios—and therefore, plans for retirement—in the long run. However the impact of inflation on these portfolios isn’t as easily observed since investors can’t see the direct effects of inflation like consumers do when they go shopping. So how exactly can high inflation hurt investment portfolios?
How does inflation affect investment portfolios?
Inflation can affect investment portfolios in different ways. Here are three of the most direct ways in which rising prices can hurt financial portfolios.
Less savings to invest
One way in which inflation can damage an investment portfolio is by decreasing the amount that an investor is able to contribute to the portfolio. Every dollar someone receives in income can either be spent or saved. If prices rise, you’ll be spending more on goods and services, and therefore, you’ll have less money to contribute to your investment portfolio. Of course, you can always choose to consume less to save more, like putting off a planned vacation. But that becomes difficult when the price of essential goods like food and gas is increasing, since those are hard to substitute.
Rising inflation also often prompts the Bank of Canada to raise interest rates. This flows through to other interest rates in the economy, such as rates on bank loans, lines of credit, and mortgages. Anyone who has any debts that are based on those rates would be paying more to service debt and will have less to save and contribute to an investment portfolio.
Asset returns may not compensate for inflation
The goal of any investment portfolio is to generate returns so that the investments can eventually be cashed out to fulfill a goal, such as paying for retirement or a house. But even if those returns are strong, they‘re diminished by rising inflation, as it eats into the real (that is, inflation-adjusted) returns of your portfolio. That is, if inflation is running at 5%, a 7% return only actually increases your real wealth by 2%.
The effects of inflation are particularly detrimental if they persist over the long run, as the impact of inflation compounds over time to hurt the real value of your returns. For example, in a world of 2% inflation, a $500,000 portfolio earning a 7% return per year for 20 years would have an inflation-adjusted value of about $1.326 million after 20 years. But with inflation at 3% yearly over that timespan, the inflation-adjusted value decreases to $1.095 million (a 17% difference). And with inflation at 5%, the inflation-adjusted value of the portfolio is about $743,000 (a 44% difference).
Different asset classes respond differently to inflation
Some asset classes perform better than others in inflationary environments, so depending on what’s in your investment portfolio, inflation may or may not have a major impact on your portfolio. Though there are no assets that can perfectly hedge against inflation risks, in general, assets that have underlying revenue streams that can increase as prices rise will do better in inflationary times than those that can’t.
Real estate, for example, is often considered a partial hedge against inflation since property owners can demand higher rent and property values often increase in inflationary times. Real assets such as infrastructure also often have revenue tied to increases in the Consumer Price Index, while ownership of commodities can provide some inflation-hedging potential since many of the commodities themselves are the cause of inflation in the first place.
Cash is usually the worst performer in inflationary times, as it earns little (if any) interest, so its value erodes over time as prices rise. Fixed rate bonds aren’t good performers either since the value of their interest payments decreases. Real return bonds—Canadian government bonds with built-in inflation protection—can be expected to perform better than plan vanilla bonds but they too don’t always provide a perfect inflation hedge.
There’s no perfect solution for inflation
When inflation rises, no consumer or investor is immune to its effects. Nevertheless, keeping a watchful eye on your budget and having a well-diversified portfolio can be critical tools that can help you manage your finances through times of rising prices.
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