How can Inflation affect your investments?

Imagine if the money you have today couldn’t buy you as much tomorrow! That’s the curious case of inflation – a financial sneak that gradually makes your money less powerful over the years. But here’s the kicker: It doesn’t just play with your wallet – it also impacts your investments. 

Inflation is an economic phenomenon that affects the purchasing power of money over time. It impacts various aspects of our lives, including our investments. Understanding how inflation influences investments is important for anyone looking to build wealth and secure their financial future. 

In this blog, we will explore the concept of inflation, understand it, and see how it can affect different types of investments. Whether you’re a seasoned investor or just starting out, this guide will help you navigate the ever-changing landscape of inflation and make informed decisions to protect and grow your wealth.

Whether you’re a seasoned pro at investing or just starting out, consider this your treasure map to navigate the tricky ways inflation and its impact on your money.

Understanding Inflation 

Imagine you drive a car that runs on petrol. At the beginning of the year, you could fill up your car’s tank with 50 liters of petrol for a total cost of ₹3,000. This cost includes the petrol price per liter, taxes, and other expenses.

Now, as the months pass, you notice that the price of petrol per liter has gone up. This increase happens because of something called “inflation.”

So, let’s assume that due to inflation, the price of petrol per liter has increased by ₹5. Now, when you go to fill up your car’s tank with the same 50 liters of petrol, it costs you ₹3,250 instead of the initial ₹3,000.

In this example, inflation is represented by the increase in the price of petrol per liter over time. Whereas, the ₹5 increase in petrol price per liter showcases the effect of inflation on a specific product.

As the price of petrol goes up, you need to spend more money to buy the same amount of fuel. In fact, we experience this in our daily life.

Inflation refers to the general increase in prices of goods and services in an economy over time. It is typically measured by calculating the percentage change in a price index, such as the Consumer Price Index (CPI). 

The Consumer Price Index shows the price development for private expenses and shows the current level of inflation when increasing. In May 2023, the inflation rate in India was at about 4.42 percent compared to the same month of the previous year.

Why is it important to consider inflation when setting financial goals?

When it comes to setting financial goals, it’s essential to consider all the factors that can impact your savings and investments. One such factor that often gets overlooked is inflation. 

Ignoring or underestimating inflation can have significant consequences on your financial plans.

Maintain the value of your money

Over time, inflation reduces the purchasing power of money. If you don’t account for inflation in your financial plans, you may end up falling short of your intended targets. 

For example, let’s say your goal is to save ₹60,000 for a laptop in 2 years, but you fail to consider an average inflation rate of about 3%. This means you might only have the purchasing power of ₹56,000.

Plan for rising expenses

As inflation goes up, the cost of living also goes up. Things we really need, like a place to live, education, healthcare, and food, become pricier. That’s why we plan and consider inflation when we make money plans. This way, we can be ready for these higher expenses.

If we don’t plan for inflation, we might not have enough money for important things in the future. This could make things tough and we might lead to some compromises in life.

Preserve long-term investments

Many financial goals include long-term investments, such as saving for a down payment on a house or funding retirement accounts. Failing to consider inflation can result in your investments not keeping pace with rising costs, leading to a stagnant or even diminishing value. 

Choosing investment options that can generate returns that outpace inflation is crucial or considering adjusting your investment contributions periodically to ensure your long-term financial goals hold their value over time.

Achieve financial stability

Inflation can significantly impact your financial stability. By accounting for inflation in your financial plans, you can avoid the risk of falling behind and struggling to catch up. 

Setting realistic targets that incorporate inflation will help you stay ahead of the rising costs and maintain a more stable financial position.

Adaptability to economic changes

The way money can buy things changes as time goes on and the economy changes. If you think about inflation when you plan your money goals, you can adjust things better when the economy changes.

This means you can change how much you save and invest based on how things are going in the economy. So, your money plans will still work well even if the economy is different.

The Impact of Inflation on Investments 

Inflation can have both positive and negative effects on investments. 

Let’s delve into some of the key ways it can influence different types of investment vehicles:    

Cash and Fixed Income

Inflation reduces the purchasing power of cash over time. If the rate of inflation is higher than the interest earned on cash deposits or fixed-income investments, the real value of these investments decreases. 

To combat this, investors may need to seek higher-yielding investments or consider inflation-protected securities like Treasury Inflation-Protected Securities (TIPS).

Stocks and Equities

While inflation may cause uncertainty in the stock market, stocks have historically been able to outpace inflation in the long run. However, during periods of high inflation, certain industries or sectors may be adversely affected. Investors should focus on companies with strong pricing power, robust business models, and the ability to pass on increased costs to consumers.

Real Estate

Real estate investments can act as a hedge against inflation since property values and rental income tend to increase with rising prices. Additionally, fixed-rate mortgages can be advantageous during inflationary periods as borrowers pay back their loans with less valuable dollars.

Commodities

Certain commodities like gold, silver, and oil have traditionally been seen as inflation hedges. When the value of currency decreases, these commodities tend to retain their value or even increase in price. Investors can consider adding commodities to their portfolios as a means of diversification.

Strategies to Mitigate the Effects of Inflation

To Safeguard your investments against inflation, consider implementing the following strategies:

Diversification

Diversifying your investment portfolio across different asset classes, such as stocks, bonds, real estate, and commodities, can help mitigate the impact of inflation.

When you diversify, you spread the risk across a variety of investments. This way some assets that perform well even during inflation, balance out the others that don’t.

Inflation-Protected Securities

Bonds issued by governments or corporations linked to inflation, such as TIPS, can protect against rising prices. These securities adjust their principal and interest payments based on changes in inflation, ensuring that your investment keeps pace with rising prices.

Dividend-Paying Stocks

Investing in companies that consistently pay dividends can be a smart strategy during inflationary periods. Dividends can provide a steady income stream that may keep pace with or exceed inflation rates.

Real Estate Investment Trusts (REITs)

REITs offer an opportunity to invest in real estate without the need for direct ownership. These companies own and manage income-generating properties, making them potentially attractive during inflationary times.

Regular Review and Re-balancing

It is important to regularly review and re-balance your investment portfolio to ensure it aligns with your financial goals and risk tolerance. Adjusting your investments based on prevailing economic conditions, including inflation expectations, can help you stay on track.

In Summary                                 

Inflation really matters when it comes to handling your money smartly. It can make the value of money you save or invest go down. But if you understand how it works, you can manage your money better.

You can build a resilient investment portfolio that stands the test of time and inflation by:

• Staying informed
• Adapting to changing economic conditions
• Seeking professional advice when needed.

When prices go up because of inflation, some investments like cash and certain types of investments lose their value. There are other things you can invest in, like stocks, real estate, and gold, which can do well even when prices rise.

Diversification, investing in inflation-protected securities, dividend-paying stocks, and REITs, along with regular portfolio reviews, are strategies that can help mitigate the negative effects of inflation on your investments.