We often reminisce about the times when our favourite snacks were half its current cost, or we may hear that at one point groceries for the month could be afforded with just $1,000. Why have the prices of items changed as much as they did? The answer can be captured in just one word, inflation.
Economists define inflation as a general rise in the price level of an economy over a period of time. We see inflation as the rise in the prices we have been noticing over the years; in bread, snacks, doubles, cars….
Inflation may be classified as headline inflation or core inflation. Headline inflation measures the total inflation in the economy and includes the changes in prices of commodities such as food and energy. On the other hand, core inflation is a measure of inflation in the economy that excludes food and energy prices. Since the prices of fuel and food items tend to fluctuate and create ‘noise’ in inflation computation, core inflation tends to be less volatile than headline inflation.
Why does this matter to us? As alluded to earlier regarding the prices of our groceries or our favourite snacks over the year, inflation reduces the spending power of the money. Inflation, eats away at the amount of goods and services that can purchase with our money. To put this into perspective, if you had $100 at the turn of the century on January 1, 2000 the value of goods and services that can be purchased today would be $33[i].
Over the long term, inflation reduces the purchasing power of your income and wealth. To put this into an even more real and personal perspective, in 2006 you could have purchased 5 doubles with $10. Today, 15 years later, with that same $10 bill you could only say “let me get two with slight”
Investing as protection against inflation
The question now is, how do you protect yourself against or lessen the effects of inflation? The answer is simple, invest! That same $100 you had at the beginning of January 2000, if it were invested in the local stock market, would be worth $574.76 today[ii]. US$100 invested in the US stock market at the beginning of the century would be worth US$502.22[iii]. While what happens in the past does not necessarily mean this is guaranteed to occur in the future, these examples show the how investing can allow our hard-earned money to win the fight against inflation.
Inflation and your investment portfolio
Up until now we would have focused mainly on how investment in stocks primarily serve as good protection against the effects on inflation on our wealth. However, there is more to investing than stocks. We may also invest in other asset classes such as bonds (fixed income), real estate and commodities. The typical investor may not have the resources to invest in large amounts of real estate and/or commodities such as wheat, gold, oil etc. However, in international markets, such as in the USA, we may gain the benefits from these asset classes through an investment vehicle called Exchange-Traded Funds (ETFs). More information regarding ETFs may be found here. There are ETFs that provide exposure to various types of bonds, commodities (as a group and individually) and real estate. Speak to your Financial Advisor on how ETFs can help you beat inflation.
Protecting your investment portfolio from inflation
As investors without a crystal ball, our best bet against inflation and other uncertainties ahead is diversification. Nobel Prize winner Harry Markowitz called diversification “the only free lunch in finance.” Diversifying our portfolio — spreading our assets across a variety of investments that may respond differently to market conditions — is one way to help manage inflation risk. However, diversification does not guarantee a profit or protect against a loss; it is a method used to help manage risk.
Commodities, such as wheat, gold, and oil, tend to move in the same direction as inflation; when they rise in price, the costs of goods and services generally increase as well. As a result, investments in commodities can offer some of the highest levels of inflation protection, though they may also be subject to frequent fluctuations in price. Higher inflation also supports alternative assets, such as real estate, which may provide some protection against inflation and a diversified source of income for investors. Commodities and Real Estate can be an investable asset class via ETFs.
Higher inflation tends to lead to higher interest rates. As interest rates rise, bond prices are expected to fall due to their inverse relationship with interest rates. Higher interest rates also negatively impact the price of stocks in the short run. However, over long horizons stock returns tend to provide real returns well in excess of inflation.
Diversifying investments across different countries and currencies may also help protect your portfolio from inflationary forces in any one country or region.
Even though we do not know for sure what the level of inflation may be in the years to come, we must be prepared! Have a chat with your financial advisor and let them guide you through your investment journey.