Inflation and Investments

When it comes to inflation, the question on many investors' minds is: "How will inflation affect my investments?" This is an especially important issue for people living on a fixed income, such as retirees. Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every dollar you own buys a smaller percentage of a good or service. The value of a dollar does not stay constant when there is inflation. The value of a dollar is observed in terms of purchasing power, which is a tangible good that money can buy. When inflation goes up, there is a decline in the purchasing power of money. For example, if the inflation rate is 1% annually, then theoretically a $1 pack of gum will cost $1.01 in a year. After inflation, your dollar can't buy the same goods it could beforehand.

There are several variations on inflation:

Deflation is when the general level of prices is falling. This is the opposite of inflation.

Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to the breakdown of a nation's monetary system. One of the most notable examples of hyperinflation occurred in Germany in 1923, when prices rose over 2,000% in a month!

Stagflation is the combination of high unemployment and economic stagnation with inflation. This happened in industrialized countries during the 1970s, when a bad economy was combined with OPEC raising oil prices.

Economists debate the causes of inflation, there is no one cause that's universally agreed upon, but at least two theories are generally accepted: Demand-Pull Inflation, which can be summarized as "too much money chasing too few goods". In other words, if demand is growing faster than supply, prices will increase. This usually occurs in growing economies. Cost-Push Inflation – Is when companies' costs go up, they need to increase prices to maintain their profit margins. Increased costs can include things such as wages, taxes, or increased costs of imports.

The impact of inflation on your portfolio depends on the type of securities you hold. If you invest only in stocks, worrying about inflation shouldn't keep you up at night. Over the long run, a company's revenue and earnings should increase at the same pace as inflation. A problem with stocks and inflation is that a company's returns tend to be overstated. In times of high inflation, a company may look like it's prospering, when really inflation is the reason behind the growth.

Fixed-income investors are hurt the worst by inflation. Suppose that a year ago you invested $10,000 in a Treasury bill with a 10% yield. Now that you are about to collect the $11,000 owed to you, is your $1000 (10%) return real? NO! Assuming inflation was positive for the year, your purchasing power has fallen and so has your real return. We have to take into account the chunk inflation has taken out of your return. If inflation was 2%, then your return is really 8%.

Inflation-Indexed Bonds

There are securities that offer investors the guarantee that returns will not be eaten up by inflation. Treasury inflation-protected securities (TIPS), are a special type of Treasury note or bond. TIPS are like any other Treasury, except that the principal and coupon payments are tied to the CPI and increase to compensate for any inflation. Because these securities are so safe, they offer an extremely low rate of return. For most investors, inflation-indexed securities simply don't make sense.