Several things occurred in 2021. COVID-19 variants continued to mutate and spread, even as vaccines were more available. Climate change generated extreme weather events worldwide, from raging storms to drought to wildfires. And inflation in the United States pushed to a 40-year high.
There are many reasons why too many dollars are chasing too few goods. But with inflation topping 8.6% (as of May 2022), investors are also facing inflation risk.
Inflation risk, also known as inflationary risk, or purchasing power risk, explains that inflation will erode the performance of an investment, an asset’s value, or a stream of income’s purchasing power. This falls under the definition of inflation, which describes an increase in the overall prices of goods and services which, in turn, decreases the purchasing power of a currency. Inflation risk can be a problem, as it can erode an investment’s returns and value increases over time.
Inflation and Investments
Because inflation has been relatively low since the global financial crisis/Great Recession of 2007-2009, it hasn’t been regarded as much of an investment risk until recently. But if inflation remains high for an extended period, it can lead to the following:
- Higher interest rates, leading to a selloff in bond markets; bonds tend to be the most vulnerable to inflation risk
- Downward pressure on equities, potentially reducing their values and returns
- Higher correlations between stocks and bonds, possibly reducing a portfolio’s diversification benefits
Inflation risk can be especially problematic for fixed-income assets (such as the above-mentioned bonds). This is because the rate of interest remains the same on many of these securities until their maturity. As inflation rises, the purchasing power of the interest rates drops. Corporate stocks tend to perform better during inflationary times, assuming that a company’s earnings and revenues increase at a similar pace.
Potential Portfolio Protections
The good news is that not all investments are created equally. Some might be stronger during period of high inflation, such as the following.
Tangible assets, such as real estate and real estate investment trusts (REITs), can be a hedge against inflation for several reasons, one of which is that rents tend to increase as other prices do. Additionally, inflation might not have much of a negative impact on property values. This, in turn, can lead to an increase in equity.
Commodities are raw materials typically produced in large quantities and sent to factories and plants for production into other goods. In most cases, these materials come from the earth; think oil, grains, and minerals. Commodity prices can increase as inflation accelerates. These investments are traded on commodities exchanges or through exchange-traded funds and mutual funds. While commodities can be helpful during inflationary times, their prices also tend to be volatile.
Inflation-protected bonds offer payouts that increase or decrease, based on inflation. They can also guarantee an inflation-adjusted principal or the original one, which ever ends up higher. Also known as Treasury inflation-protected securities, these pay out based on inflation indexes (such as the Consumer Price Index). This asset is available through direct bonds, a bond EFT, or a bond fund.
Another way to potentially reduce inflation risk is through a carefully balanced investment portfolio. For assistance in this area, it’s a good idea to work with a financial advisor or planner who has a grasp on inflation.
A bond’s yield, price and total return change daily and are based on changes in interest rates, market conditions, economic and political news, and the quality and maturity of its investments. In general, bond prices fall when interest rates rise, and vice versa. Unless otherwise noted, the actual amount and timing of distributions or interest payments are not guaranteed and may vary. Investing involves risks, including the loss of principal. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk. Examples shown are for illustrative purposes only. This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice, meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.