Inflation tends to corrode the value of investment portfolios if not managed efficiently. Therefore, it is necessary to plan investments in a way that beats inflation.
What is Inflation and How it Impacts Investments?
Inflation is the rate at which the purchasing power of any currency declines. The price of goods and services keeps increasing over time due to inflation. As a result, the same amount of money will be able to buy less products and services, and the cost of living goes up.
Inflation impacts different types of investments differently. Higher inflation means that the value of their investments hikes and inflation adds more value to their investment portfolio for those who have invested their funds in assets like real estate and commodities. However, for investors who hold more cash, the value of money erodes with inflation as the same amount of cash will allow them to buy fewer goods or services. Thus, inflation can have a corrosive effect on many investments.
For example, if someone buys a property for $10,000 this year and the inflation rate is 8%, the value of the property after a year will be $10,800. However, if someone holds cash of $10,000 in the same inflation environment, the value or purchasing power of the same amount will drop down to $9,200 owing to inflation.
How to Beat Inflation with Investment
Therefore, to overcome the impact of inflation on investments, it is critical to calculate the real returns of investments net of inflation. If your earnings do not grow more than the average inflation rate, and you do not invest in inflation-proof securities, your savings will either stay the same in value or shrink because of inflation.
Investors use a variety of investment types and asset allocation plans that grow in value with the increase in inflation. As a result, the portfolio does not erode and keeps growing despite inflation. Some ways to stay ahead of inflation with investment include:
Investment in Equities and Equity Mutual Funds: Investment in equities and equity mutual funds is preferred in inflationary environments as the value of bonds decreases. As inflation goes up, interest rates also hike, leading to a fall in bond prices. On the other hand, long-term investment in stocks, value stocks in particular, usually generates higher returns than the average rate of inflation. When investors invest in stocks, either directly or through SIPs in mutual funds, they invest over a long period and generate returns that beat inflation by a significant margin.
Investment in Dividend-Paying Stocks: Another excellent method to beat inflation with investment is investing in dividend-paying stocks. Dividends tend to keep up with inflation. In the cases of most of the established dividend-paying stocks, the dividend yield has been higher than the inflation rate. Thus, investing in stocks that pay high dividends can go a long way in making your investments inflation-proof. Additionally, the increasing nature of dividends also plays a significant role. If a large sum of dividend is paid in one go, and the value does not keep increasing, the big dividend payment can be compromised by inflation in the long-term.
Investment in Real Estate: Investing in real estate is a popular choice among investors to beat inflation. With the rise in inflation, the value of the real estate property also goes up. As a result, the resale value and the rental payments from real estate investment increase, often matching or beating inflation. Thus, by investing in real estate, investors can keep pace with the rising prices of goods and services, and not let their investment portfolio erode.
Investment in Inflation-Indexed Securities: One of the best places to invest against inflation is the Treasury Inflation-Protected Securities (TIPS). TIPS is a US Treasury bond that is linked to an inflationary gauge. The bond value is maintained by making adjustments to its price in correlation with inflation; its principal value grows with inflation, and so do the interest payments. Thus, investment in TIPS helps investors combat the negative impact of inflation and retain the value of their investment portfolio.
Global Diversification: Another commonly used method to beat inflation is diversification across different geographies. The high inflation and volatility of one or few assets of the investment portfolio can be hedged by lower inflation in other assets belonging to a different geographical location. Thus, the overall impact of inflation can be nullified by spreading investments across different countries and economies.
As a bottom line, if investments are not managed keeping inflation in mind, their value and net returns may go down over a period of time. Therefore, it is essential to consider your time horizon, risk tolerance, and financial goals to choose investment strategies and assets that protect your funds against inflation and beat inflation and generate positive returns net of inflation.