Inflation is wreaking havoc on budgets across the country. With the Consumer Price Index (a key indicator of inflation) hitting a 40-year high earlier this year, it’s an economic issue that is affecting every American.
As an investor, the idea of changing your portfolio choices has likely crossed your mind. You may be tempted to make adjustments to combat this high inflation. But should inflation affect your portfolio selection? Here’s what you need to know.
The impact of inflation on your portfolio
Like it or not, it looks like inflation will be around for a while. Although the Federal Reserve works to combat inflation by raising interest rates, it will likely take some time to moderate our current inflationary environment.
The CPI cooled slightly from July 2022. But if inflation stays above 8%, everyone will continue to feel the pinch. It’s inevitable that inflation will have an impact on your portfolio, but it can affect different assets in different ways. Here’s how inflation will affect stocks and bonds.
Stocks are considered to be more volatile investments than bonds. If you’ve been an investor for any length of time, you’ve likely noticed how quickly stock prices can rise and fall. Over the past couple of years, it’s been a particularly rough ride for investors with multiple stock portfolios.
Although stocks are generally in a better position to keep up with inflation than bonds, not all stocks are able to offset high inflation. For example, stocks in the energy sector may be able to keep up with inflation better than stocks in the technology sector. This is because energy costs are directly linked to inflation. Consumers may be able to bypass the latest tech gadgets, but they can’t easily avoid paying for energy.
Bonds are often considered a more stable investment option than stocks. The lower risk associated with bonds makes them more stable, but the lack of risk also leads to lower returns. And when inflation is rampant, bonds often can’t keep up.
One problem with inflation for bond investors is that because bonds are debt-based, they usually have a specific interest rate. So when the Federal Reserve starts raising interest rates in an effort to fight inflation, the real yield on existing bonds falls.
However, there is an exception to this rule. Treasury inflation-protected securities are bonds that are specifically designed to keep pace with inflation. Once you buy a TIPS, the principal will increase with inflation and decrease with deflation. Changes are made based on changes in CPI and interest is paid twice a year at a fixed rate.
Stocks and bonds aren’t the only investment options out there. Many investors have a portion of their portfolio allocated to other types of assets.
Investing in real estate through income-producing properties or real estate investment trusts (REITs) gives your portfolio exposure to a different area of the economy. In general, real estate is thought to keep pace with inflation, but individual factors of a local market can affect this trend.
Other investments that generally keep pace with inflation include precious metals and some commodities, such as crude oil, natural gas, grains and other agricultural products. Many investors choose to add gold or silver to their portfolios as a hedge against inflation.
The downside to some of these alternative investments is that you may need more knowledge to get started. You may even need to make a commitment to own and protect a physical asset, such as an income-producing individual property.
Consider other markets
Inflation does not always affect markets around the world in the same way at the same time.
Although the US market is experiencing severe inflation, not every country has the same problem (or at least not to the same extent). Taking an opportunity to invest in an emerging market comes with risk, but some foreign markets may give you a better chance of keeping up with inflation.
Should inflation affect your portfolio?
It is clear that inflation will have a negative impact on most investment portfolios.
The inflationary environment makes it difficult for assets to produce a positive return. After all, when inflation is over 8%, you’ll need investment returns of at least 8% just to keep pace. This is easier said than done.
It’s best to build a diversified portfolio along the way to minimize the impact of inflation on your returns. Here are some best practices to consider when building a portfolio designed to keep pace with inflation:
Define your goals
Inflation is a widespread economic influence that erodes purchasing power. When inflation is around, it affects everyone’s finances. But you will have to decide for yourself what kind of course you want to chart with your investments.
Everyone wants to avoid the impact of inflation. However, this is not the only factor to consider when building a portfolio. You will also want to determine what level of risk you are comfortable with. It’s okay to take more or less risk based on your preferences.
Instead of jumping into a ton of changes, start by assessing where your portfolio currently stands. If you are not already diversified, then it may be time to make some changes.
The proper separation between stocks and bonds is the first number to consider. As an investor, you will need to decide which ratio is right for you. In general, investors with a lower risk tolerance increase their portfolios with more bonds, and investors with a higher risk tolerance are comfortable with more volatile stocks in their portfolios.
But when it comes to intense inflation, having too much of your portfolio in bonds can actually backfire. Ultimately, you’ll need to weigh the volatility risks associated with the stock market against the draining power of inflation.
In the case of inflation, you may decide to favor stocks a little more. Or, if you’re buying bonds, TIPS and their inflation hedges may deserve a place in your portfolio.
Which sectors should you look at?
When it comes to stocks, some will perform better than others in an inflationary environment. As an investor, it is important to keep an eye on several key sectors. Be sure to check out Q.ai investment packages designed around specific investment areas, such as energy, inflation-resistant or growth stocks.
The energy sector is closely linked to the Consumer Price Index. The price of fuel, gasoline, electricity and natural gas as a utility all directly affect the CPI. Since the CPI is a key measure of inflation, the correlation is clear.
When energy prices rise or fall, the CPI is affected. With this, the energy sector is poised to do well when the economy is facing inflationary pressures. This is because consumers in general cannot avoid purchasing the energy needed to function in society. For example, even if the price of gasoline is high, many people still buy their regular amount because they simply need to travel.
Consumer staples like groceries tend to do well when inflation is around. The reality is that shoppers still need to get their weekly supply of bread, eggs and milk. Even if prices are higher, many families are forced to spend more on basic items found on grocery shelves across the country.
Because of this, investing in major stocks is a good way to hedge your bets against inflation.
Growth stocks usually have minimal cash flows. When times are good and inflation is manageable, growth stocks can rise. But when the economy is facing tough times, consumers are forced to make changes in their spending just to make ends meet. With those budget cuts, it becomes harder for companies that don’t provide a core service to survive.
Stocks based on growth will take a heavier than average inflationary hit, so keep that in mind when creating your investment portfolio.
Some investments are better suited to tolerate an inflationary environment than others. As the US economy settles into inflationary times, it’s important to keep a careful eye on your portfolio. But it’s usually not the right time to adopt big changes if your portfolio isn’t diversified enough to weather the coming storm.
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