How inflation affects your investments
Inflation can have a significant impact on your savings and investments, so it’s vital to explore options which have the potential to generate returns that can beat it.
Here, we explain what inflation is, how it affects investments, and which types of investment may provide protection against it.
What is inflation?
Inflation is the rate at which the prices of the goods and services we use every day, such as food, transport and energy, increase over time. Inflation usually happens when an economy grows or when there is a sharp increase in the supply of money.
The most common measure of inflation in Hong Kong is the Consumer Price Index. This measures the average change in the current and past prices of a sample "market basket" of goods from a variety of categories including housing, food, transportation, and clothing typical of a household whose monthly expenditure is between around $4,000 and $16,000, which covers about half the households in Hong Kong.
The higher the inflation rate, the more the real value of your money falls because you’re having to spend more to buy these items. Even when nominal interest rates are rising and returns on cash savings are higher, they can soon be wipe out by rising living costs.
For example, if the inflation rate is 3% and stayed at this level for a year, a $1,000 spend now would cost you, on average, $1,030 in 12 months’ time.
Why inflation matters for your savings and investments
Inflation affects your savings and investments because if the nominal returns you’re making from them aren’t as high as the inflation rate, this effectively means the purchasing power of your wealth is gradually eroded over time.
Based on the same example above, if inflation is at 3% and your investments return 3%, then your real return is effectively zero.
Over long-term periods, inflation can significantly reduce returns from shares, bonds and cash, which is why it’s vital when calculating how much a investment is likely to produce, that investors consider the likely real return, which is determined by factoring in the effects of inflation.
How investors can protect themselves from inflation
The good news is that there are ways for investors to prevent inflation chipping away at their returns. For example, inflation-linked bonds provide one way for investors to shield themselves from the impact of inflation on their portfolio.
Historically, short duration inflation-linked bond performance has been more closely correlated to inflation itself than other inflation strategies, and at the same time can help mitigate interest rate risk. The longer a bond’s term, the more its price may be affected by changes in interest rates.
Stocks also provide the potential to produce returns that outpace inflation, and over long-term periods have tended to provide higher returns than other asset classes, although of course past performance can’t be relied on as a guide to what will happen in future.
Inflation is usually high when the economy is strong. Many companies benefit during these periods, as they may be able to sell their goods and services for more than they might when the economy is sluggish. This can potentially boost their share price, although some companies won’t fare so well during periods of strong economic performance because they may have to pay more for raw materials and wages.
Investing in individual companies can therefore be a highly risky strategy, as whether inflation benefits or hinders them depends on the particular business involved. Investors may instead prefer to opt for a pooled fund, where their money, along with that of other investors, is invested in a wide spread of stocks selected on their behalf by a professional fund manager, helping to build a diversified portfolio.
It’s important to remember though that there is still a risk of losses when you invest in funds, so you must be prepared to accept that you could get back less than you put in, and there are no guarantees that the value of your investment will keep up with inflation.