How Dangerous Is Inflation for Your Investments?

As the economy gets back on track, shortages of workers, commodities, things like computer chips have caused both shortages and price increases. There is a fair amount of honest debate about whether or not most of the current bout of inflation is temporary or the start of something prolonged and worse. Assuming that we are entering into a serious inflationary cycle, how dangerous is inflation for your investments? Part of the answer depends upon what your investments are.

Is Inflation a Risk When Investing?

To the extent that your investments give you a set annual return such as with CDs, Treasuries, corporate bonds, or simply a passbook savings account, you will typically find yourself receiving negative real interest rates. The point of saving and investing is to increase your purchasing power in years to come. While these investments will give you a positive return in the number of dollars that you have, those dollars will be worth less when measured in purchasing power. Thus the risk of inflation is that your real net worth when measured by your ability to pay for things that you want or need will be reduced despite steady, diligent investing and saving.

What Are the Negative Effects of Inflation on Investors?

The first negative effect of inflation, as we have already noted, is that interest-bearing investments lose ground in purchasing power. Another negative effect can be less easy to spot. Investors get worried when inflation ramps up and start choosing riskier ways to invest and investments. This sort of behavior includes staying with a stock or index as it becomes more and more clear that a bull market is nearing its end. Or, an investor neglects to rebalance their portfolio as stocks take up a greater proportion. This may make sense in the middle of an inflationary cycle but it leaves the investor open to market risks that having a “cash” portion of their portfolio is meant to protect against.

How Dangerous Is Inflation for Your Investments
Loss of Purchasing Power From 1% Versus 5% Inflation

What Investments Are Safe From Inflation?

Over the years the value of homes and investment property tends to go up with inflation. This is always more pronounced in areas where prices are already higher. The old adage that the most important factors in real estate are location, location, and location applies with greater force when inflation drives prices up. When you are talking about your home, you won’t necessarily sell it and take a profit because you need to buy another and inflation has driven up prices across the market.

What Investments Do Well During an Inflationary Cycle?

Gold is a traditional favorite when inflation ramps up but so are other commodities. In the stock market, technology and consumer goods tend to do well too. A good rule of thumb is to avoid getting into growth stocks whose stock prices are held up by the expectation of futures earnings. When those future earnings are made less valuable in terms of purchasing power, it hurts the stock as well. Vehicles like REITs can do well in these times. And, when inflation is rampant, collectibles go up in price. These include fine art, rare coins, and vintage cars. If you have the knowledge and judgement to make good choices with collectibles they can be an excellent hedge against inflation. But, if you are naïve and make bad choices you will lose a lot of money which in turn will be worth even less because of inflation!

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