Inflation is continuing to be a hot topic with investors, and it’s not hard to imagine why. It can be a powerful force that affects our daily lives and has the potential to impact investments.
So how does inflation actually work, and why does it affect investments?
First the fine print. While this article can give you helpful tips, we can’t give you personal advice. Investments can fall as well as rise and you could get back less than you started with.
What is inflation?
Inflation is measured as a percentage and is the rate at which the price of goods and services is rising. So, if inflation is 5%, that means that goods and services would cost you 5% more today compared to a year ago.
In the UK, inflation is measured by the Consumer Price Index (CPI) and has a target set by the government. It’s the Bank of England’s job to meet the target, which is 2%.
CPI is calculated by measuring a basket of goods and services and comparing the cost against the price of that same basket a year ago. In real terms, as inflation starts to make an impact and prices rise, you can do less with your money, as it doesn’t go as far.
How does inflation affect investments?
If you’re investing in funds, inflation can have an impact on the value of your investments. But the impact doesn’t mean it’s all bad.
A fund that’s investing in fixed income investments, like bonds, can be particularly vulnerable to the effects of inflation.
When inflation is high, the fixed payments that investors get in the future from bonds (called ‘coupons’) are worth less in real terms. If a bond pays an annual interest rate that is lower than inflation, the real return on the bond is negative.
There’s also the possibility that investors shy away from bonds if banks raise interest rates to curb inflation. When interest rates rise, the yield on new bonds increases. This makes existing bonds with lower yields less attractive to investors, decreasing their value.
But don’t lose hope!
Inflation can also positively impact investments. Despite higher costs, some companies are better equipped at managing inflation than others. As prices rise, the profits of some companies may increase, which should improve their share price. That means some funds that invest in equities could actually benefit from inflation. Given time, investing in equities can be a way to buffer against inflation.
If all this talk about bonds and equities is boggling your brain, our handy jargon buster can help.
3 tips to help investors with inflation
- Understand your investments
If you’re someone who likes to invest and let it do its thing, there’s no problem in that. Understanding your portfolio doesn’t mean having to be immersed in the detail, unless you want to be.
It won’t take long to have a look at what you’re investing in. This can help you to make sense of why your investments are doing what they’re doing in response to inflation.
- Think about diversification
It seems like diversification is the answer to everything when it comes to investing. We’ll let you in on a secret. It sort of is.
A diversified portfolio actively reduces the effects of inflation and market fluctuations. This helps to spread out overall risk.
It can be really easy to think that if you’re investing in a fund, then you’re diversified and you don’t need to do much else. That’s not quite always the case. Just because you’re investing in a fund, that doesn’t mean that fund is built to withstand inflation, or even rising interest rates.
Make sure your investments span different investment types, different geographies and have the right risk level for you and your goals. This can help you to keep calm and carry on when the markets are in flux.
- Don’t try and time the market
It’s an old saying—buy when prices are low, sell when they’re high. But times have changed! Trying to time the market is like being a pilot on the ground waiting for sunshine on a rainy day so they can take off. You can waste time looking for a break in the clouds rather than being in them and still flying to your destination.
You can still get to where you want to go, even if the weather isn’t ideal. That’s the same for being invested in the market. It might not be without its turbulence but it’s better to be in it, than waiting for the perfect time. Being in the market longer means you’re able to weather its ups and downs.
Remember, the value of investments can go up and down, so you may get back less money than you put in. Tax depends on your individual circumstances and the regulations may change in the future.