top of page

Inflation and Investing: What a Beginner Needs to Know / By: Fathima Shaikh

If you're a beginner investor, you may be interested in the term inflation that economists and the news mention often and what that term means. Inflation is a critical economic factor that can significantly impact various aspects of our lives, including investment decisions. As a beginning investor, understanding inflation and its effects is crucial for making informed choices to safeguard and grow your hard-earned money. 

According to U.S. midterm exit polls, a staggering 31 percent of voters cited inflation as the "most important issue" influencing their voting decisions, surpassing all other factors (Cato, 2021). Inflation can be defined as the general increase in the prices of goods and services over time, leading to a decrease in the purchasing power of money. While moderate inflation is considered healthy for economic growth, excessive inflation can be detrimental to both individuals and the overall economy. As an investor, understanding how inflation impacts your investments is vital for maximizing returns. 

When examining historical data of S&P 500 returns by decade and adjusting for inflation, the results reveal a notable pattern. The highest real returns, which are nominal returns minus inflation, occur when inflation is within the range of 2% to 3% (Investopedia, 2021). This finding highlights the significance of inflation on investment outcomes. Too high or too low inflation can hinder investment performance, making the sweet spot of 2% to 3% particularly desirable for investors. “Frequently, investors underestimate the significance of inflation due to its gradual nature. For instance, assuming a future inflation rate of 3%, the purchasing power of $1,000 would diminish to approximately $744 after 10 years, $554 after 20 years, and $412 after 30 years,” noted Andrew Ish, CFA, CPA, CFP® Financial Planner with Prepared Financial Planning LLC 

As a beginning investor you might want to consider a variety of factors to navigate the impact of inflation on your investment portfolio. The first and most common tip is diversification, which is varying your investments across asset classes, such as stocks, bonds, real estate, and commodities. This can help mitigate the effects of inflation. Different assets tend to respond differently to inflationary pressures, ensuring that your portfolio remains resilient. Another important factor is understanding real returns. Real return is what is earned on an investment after accounting for taxes and inflation. Real returns are lower than nominal returns, which do not subtract taxes and inflation. You need to ensure your real returns meet the value that you are hoping to achieve for your financial goals. “Be mindful, over longer time periods, inflation has historically posed a greater risk than the stock market. Consequently, a meaningful portion of my client's portfolios typically include equities,” stated Andrew Ish, Financial Planner with Prepared Financial Planning LLC 

While in a high inflation environment, something to be cautious about are fixed-income investments especially longer maturity securities. Bonds may suffer in a high-inflation environment as their fixed interest payments may lose value in real terms. For example, during 2022 when inflation averaged 8%, the Bloomberg U.S. Aggregate Bond Index dropped 17% intra-year and finished the year down 13%. Therefore, during high inflation consider adjusting the mix of your bond holdings to include inflation-protected securities. On the contrary, equities have historically shown resilience in the face of moderate inflation. Companies have the potential to increase their revenues and profits in response to rising prices, making stocks an attractive option for combating inflation. Other asset classes that tend to keep pace with inflation are real estate investment trusts (REITS) and commodities. 

To conclude, inflation is a powerful force that can significantly impact your investments. As a beginning investor, educate yourself about inflation's effects and design a well-rounded investment strategy that takes inflation into account. By staying informed and making prudent choices, you can navigate the complexities of inflation and work towards achieving your long-term financial goals. 


Works Cited:


Comments


bottom of page