Inflation is wreaking havoc on budgets across the nation. With the Consumer Price Index (a key indicator of inflation) hitting a 40-year high earlier this year, it’s an economic issue that is affecting every American.
As an investor, the idea of switching up your portfolio selections has likely crossed your mind. You may be tempted to make adjustments to combat this sky-high inflation. But should inflation influence your portfolio selections? Here’s what you should know.
The impact of inflation on your portfolio
Like it or not, it looks like inflation is going to be around for a while. Although the Federal Reserve works to combat inflation with interest rate hikes, it will likely take a bit of time to tame our current inflationary environment.
The CPI cooled slightly as of July 2022. But if inflation stands at over 8%, everyone will continue to feel the pinch. It’s unavoidable that inflation will have an impact on your portfolio, but it may affect different assets in different ways. Here’s how inflation will impact stocks and bonds.
Stocks are considered to be more volatile investments than bonds. If you’ve been an investor for any amount of time, you’ve likely noticed how quickly stock prices can rise and fall. Over the last two years, it’s been an especially bumpy ride for investors with stock-heavy portfolios.
Although stocks are generally in a better position to keep up with inflation than bonds, not all stocks are able to offset sky-high inflation. For example, stocks in the energy sector may be able to keep up with inflation better than stocks in the tech sector. That’s because energy costs are tied directly to inflation. Consumers might be able to skip out on the latest tech gadgets, but they cannot readily avoid paying for energy.
Bonds are often considered a more stable investment opportunity than stocks. The lower risk associated with bonds makes them more stable, but the lack of risk also leads to lower returns. And when inflation is running rampant, bonds often cannot keep up.
One problem with inflation for bond investors is that because bonds are debt-based, they’ve usually locked in a specific interest rate. So when the Federal Reserve starts to raise interest rates in an effort to combat inflation, the real yield drops for existing bonds.
However, there is an exception to this rule. Treasury Inflation-Protected Securities are bonds that are specifically designed to keep pace with inflation. After you purchase a TIPS, the principal will increase with inflation and decrease with deflation. The changes are made based on the changes to the CPI, and interest is paid out twice a year at a fixed rate.
Stocks and bonds aren’t the only investment opportunities out there. Many investors have a portion of their portfolios allocated to other types of assets.
Investments in real estate through income-producing properties or real estate investment trusts (REITs) give your portfolio exposure to a different area of the economy. In general, real estate is thought to keep up with inflation, but the individual factors of a local market could impact that trend.
Other investments that generally keep pace with inflation include precious metals and some commodities, such as crude oil, natural gas, grains, and other agricultural products. Many investors choose to add gold or silver to their portfolios as a hedge against inflation.
The downside to some of these alternative investments is that you might need more knowledge to get started. You might even have to make a commitment to owning and protecting a physical asset, as with an individual income-producing property.
Consider other markets
Inflation doesn’t always impact markets around the world in the same way at the same time.
Although the U.S. market is experiencing severe inflation, not every country has the same problem (or at least not to the same extent). Taking an opportunity to invest in an emerging market comes with risk, but some foreign markets might give you a better chance of keeping up with inflation.
Should inflation influence your portfolio?
It’s clear that inflation will have a negative impact on most investment portfolios.
The inflationary environment makes it difficult for assets to produce a positive return. After all, when inflation is over 8%, you’ll need investment returns of at least 8% just to keep pace. That’s easier said than done.
It’s best to build out a diversified portfolio along the way to minimize the impact of inflation on your returns. Here are some best practices to consider as you build a portfolio designed to keep pace with inflation:
Define Your Goals
Inflation is a pervasive economic influence that eats away at purchasing power. When inflation is around, it impacts everyone’s funds. But you’ll have to decide for yourself what kind of course you want to chart with your investments.
Everyone wants to avoid the impact of inflation. However, that’s not the only factor to consider when building a portfolio. You’ll also want to determine what level of risk you are comfortable with. It’s okay to take on more or less risk based on your preferences.
Instead of jumping into a ton of changes, start by assessing where your portfolio currently stands. If you aren’t already diversified, then it might be time to make some changes.
The right split between stocks and bonds is the first number to consider. As an investor, you’ll have to decide which ratio is right for you. Generally, investors with a lower risk tolerance beef up their portfolios with more bonds, and investors with a higher risk tolerance are comfortable with more volatile stocks in their portfolios.
But when it comes to intense inflation, having too much of your portfolio in bonds could actually backfire. Ultimately, you’ll have to weigh the volatility risks associated with the stock market against the draining power of inflation.
In the case of inflation, you might decide to favor stocks a bit more. Or, if you’re buying bonds, TIPS and their inflationary protections might deserve a place in your portfolio.
What sectors should you watch?
When it comes to stocks, some will perform better than others in an inflationary environment. As an investor, it’s important to keep an eye on a few key sectors. Be sure to look into Q.ai investment kits designed around specific investment areas, like energy, inflation-resistant, or growth stocks.
The energy sector is tied closely to the Consumer Price Index. The price of fuel, gasoline, electricity, and natural gas as a utility all play directly into the CPI. Since the CPI is a key measurement of inflation, the correlation is clear.
When energy prices rise or fall, the CPI is impacted. With that, the energy sector is poised to do well when the economy is facing inflation pressures. That’s because consumers generally can’t skip purchasing the energy needed to function in society. For example, even if the price of gasoline is high, many people still purchase their regular amount because they simply need to commute.
Core consumer staples, like groceries, tend to get along just fine when inflation is around. The reality is that shoppers still need to pick up their weekly supply of bread, eggs, and milk. Even if the prices are higher, many families are forced to spend more on basic items found on grocery shelves across the country.
Because of this, investing in staple stocks is a good way to hedge your bets against inflation.
Growth stocks typically have minimal cash flow. When times are good and inflation is manageable, growth stocks can soar. But when the economy is facing hard times, consumers are forced to make changes to their spending just to make ends meet. With those budget cuts, it gets more difficult for companies without an essential service offering to survive.
Growth-based stocks will take a harder-than-average inflationary hit, so keep this in mind when setting up your investment portfolio.
Some investments are better suited to tolerate an inflationary environment than others. As the U.S. economy settles into inflationary times, it’s important to keep a careful watch on your portfolio. But it’s usually not the right time to enact major changes unless your portfolio isn’t diversified enough to weather the coming storm.
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