Q: I am hearing a lot about inflation. Is this something that could impact my investments and should I be concerned?
Let’s start with a brief explanation of what inflation is and how it works. Inflation, by definition, is the general rise of prices for goods and services in the economy. To see the impact of inflation, look no further than the cost of a gallon of milk over the past 40+ years. In 1975 a gallon of milk cost $1.32 and in 2020 this cost increased to $3.32 (this represents a 2% average annual increase of the cost of milk). While there is not much we can do about inflation, the Federal Reserve (the Fed) was created in 1913 with the objective of maintaining a stable and secure economy. The Fed’s two main goals are to keep prices stable and maximize sustainable employment. The Fed has several tools at their disposal to help achieve these goals. These tools allow the Fed to regulate the supply of money in the economy by adjusting extremely short-term interest rates. For example, when the economy is showing signs of slowing, the Fed will begin to reduce short-term interest rates in an effort to bring down borrowing costs and spur economic activity. The reverse is also true. When the economy is heating up, the Fed will increase interest rates to help cool down the economy in an effort to avoid a spike in inflation.
Inflation can actually be good for stocks, up to a certain point. As I mentioned above, it is common for the Fed to gradually increase interest rates during an economic expansion. These periods of economic expansion are often associated with rising employment, leading to increased consumer spending, which translates into higher corporate profits. Higher corporate profits will most likely result in a higher demand for the company’s stock, which will translate into rising stock prices. When the economy gets too hot, the Fed will most likely speed up the increase in interest rates to help avoid a spike in inflation. When this occurs, corporations will start to feel the squeeze, ultimately leading to reduced profits. This in turn will cause investors to sell stocks, leading to a decline in stock prices.
On the other hand, we see the opposite effect of inflation on bonds. Rising interest rates have a negative impact on bondholders. As interest rates increase, the value of the bonds they own will decrease. As we saw above, stocks can do well (at least for a period of time) in an inflationary environment, however bonds will not have the same fate. In addition, if the bond an investor owns pays a fixed rate of interest and with the cost of goods increasing, the interest payments he receives may not be enough to keep up with the rise in prices. This may cause the investor to sell a portion of his holdings, when the value of his portfolio is down, just to keep up with the increase in the goods he needs to purchase. This problem is exacerbated over time. The longer duration the bond, the larger the impact inflation will have on its value.
Is there a way I can hedge my portfolio against inflation?
One of the main ways to hedge against inflation is by investing in real estate and/or commodities (i.e., gold, oil, copper, lumber, etc.) Think of a commodity as the inputs needed to create a particular good or service. For example, think about the materials you need to build a house. One of the most important materials is lumber. Lumber in this example would be considered a commodity. Unlike bonds, and to some extent stocks, commodities tend to increase in value during inflationary periods. As the demand for goods and services increases, the price of those goods will increase, which will increase the prices of the commodities it takes to produce those goods and services. So, if an investor’s goal is to make sure their portfolio keeps pace with inflation it may be a good idea to add some commodities into the mix.
Inflation is a natural force in the economy and will ebb and flow over time. There will be periods of high inflation, experienced during the 1970s, and periods of time with low inflation, which we have experienced over the past 20 years. Unfortunately, no one has a crystal ball that can forecast the future, including the ability to predict the rate of inflation nor the performance of the financial markets. When it comes to investing, it is important to understand your risk tolerance and focus on diversification. Knowing your risk tolerance is the first step because it will help you understand how you are wired as an investor. Are you one who likes the thrill of riding a rollercoaster? Or would you prefer floating down the lazy river in a tube? Once known, you can begin to develop your asset allocation (i.e., how much should be in stocks, bonds, real estate, and commodities). From there, you want to make sure you diversify your holdings within each asset class by investing in low-cost ETFs or mutual funds.
