Inflation and Investing - What Changes
There has been a lot of talk about inflation recently and the impact on investment strategies. For many investors, they have never lived in an environment with elevated inflation levels so there is a lot of confusion on how to think about investing in this environm
Let’s start with the basics. Inflation represents rising prices of the things we buy every day – food, fuel, restaurants, etc. There are various indices that track the change in these prices. The most well-known is the consumer price index (CPI). The index measures a “basket of goods” and keeps the basket constant so you can see changes over time. For example, the basket always includes fuel (gasoline) so the recent increases in the prices at the gas station have had an impact on the CPI/inflation. Since gas prices are only one component of the CPI, an increase in gas prices would only have a modest increase on the overall CPI increase/inflation rate. But, as we all know, prices for everything have been increasing lately and we’ve all heard about inflation being on the rise.
So, simply put, if inflation is at 5%, then you should feel that what cost you a dollar a year ago, now costs you $1.05, and it will cost you a little over $1.10 next year. We haven’t had noticeable inflation since the 80’s so most of us don’t really remember what it was like. Could write another article on that but let’s specifically talk about investing in an environment with inflation.
The most important concept to consider is under a higher inflation environment you need to consider returns excluding inflation. That’s because the value of your money decreases every year. So, in our example before, if prices increase at 5% every year, today’s dollar buys you 5% less next year and more than 10% less the year after, and so on. So, if you have an investment that returns 5% per year but inflation is at 5% per year, then your dollar will become $1.05 after a year but since prices have increased by 5%, that $1.05 will buy you the same basket of goods that $1.00 bought a year ago. In other words, you get a REAL return of zero on your investment since the money depreciates as fast as the investment appreciates.
That’s why interest rates are increasing. If someone had $1 to invest and an investment was only returning 3% (and inflation was 5%), your investment would actually have a negative return (3% - 5% = -2%).
So, what’s going to happen in this higher inflation environment? First, as we already mentioned, interest rates will go up to attract investors. This includes both investments (Treasury Bills, GIC’s, etc) and loans, including mortgages. You’ve probably noticed mortgage rates going up too.
Impacts on other investments (stocks) are more complicated. As interest rates rise, more people will move money from bonds to stocks, putting downward pressure on stocks. On the other hand, many companies will see their profits rise because of inflation (think oil stocks). So, the impact on stocks will be mixed.
With inflation, investing gets more complicated but the same rules always apply. Get a diversified portfolio and invest for the long term.