Inflation is wreaking havoc on budgets across the country. With the consumer price index (a key gauge of inflation) hitting a 40-year high earlier this year, it’s an economic problem that affects all Americans.
As an investor, the thought of changing your portfolio selections has probably crossed your mind. You may be tempted to make adjustments to combat this high inflation. But should inflation influence your portfolio selection? Here’s what you should know.
The impact of inflation on your portfolio
Like it or not, it looks like inflation is going to stick around for a while. Even as the Federal Reserve works to combat inflation with interest rate hikes, it will likely take some time to tame our current inflationary environment.
The CPI cooled slightly from July 2022. But if inflation stays above 8%, everyone will continue to feel the pinch. It’s inevitable that inflation will have an impact on your portfolio, but it can affect different assets in different ways. Here’s how inflation will affect stocks and bonds.
Stocks are considered more volatile investments than bonds. If you’ve been an investor for a while, you’ve likely noticed how quickly stock prices can go up and down. It’s been a particularly bumpy ride for investors with equity-heavy portfolios over the past couple of years.
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 can keep up with inflation better than stocks in the technology sector. This is because energy costs are directly linked to inflation. Consumers may be able to skip the latest tech gadgets, but they can’t easily 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 means a lower return. And when inflation soars, bonds often can’t keep up.
One of the problems with inflation for bond investors is that because bonds are based on debt, they usually have a specific interest rate locked in. So when the Federal Reserve starts raising interest rates in an effort to fight inflation, the real yield on existing bonds falls.
However, there is an exception to this rule. Treasury inflation-protected securities are bonds designed specifically to keep pace with inflation. After you buy a TIPS, the principal will increase with inflation and decrease with deflation. Changes are made based on CPI changes and interest is paid 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.
Real estate investments through income-producing properties or real estate investment trusts (REITs) give your portfolio exposure to a different area of the economy. Real estate is generally believed to keep up with inflation, but individual factors in a local market could affect this 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 may need more knowledge to get started. You may even need to commit to owning and protecting a physical asset, such as individual income-producing property.
Consider other markets
Inflation does not always affect markets around the world in the same way at the same time.
Although the US market is experiencing severe inflation, not all countries have the same problem (or at least not to the same extent). Taking the opportunity to invest in an emerging market comes with risk, but some foreign markets may offer you a better chance of keeping up with inflation.
Should inflation affect your portfolio?
It is 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 above 8%, you’ll need an investment return of at least 8% just to keep up. This is easier said than done.
It’s best to build a diversified portfolio along the way to minimize the impact of inflation on your returns. Here are some best practices to consider when building a portfolio designed to keep pace with inflation:
Define your goals
Inflation is a widespread economic influence that consumes purchasing power. When there is inflation, it affects everyone’s finances. 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, this is not the only factor to consider when creating a portfolio. You’ll also want to determine what level of risk you’re comfortable with. It’s okay to take more or less risk based on your preferences.
Instead of jumping into a bunch of changes, start by assessing where your portfolio currently stands. If you’re not already diversified, it might be time to make some changes.
The correct split between stocks and bonds is the first number to consider. As an investor, you will have to decide which ratio is right for you. In general, investors with a lower risk tolerance enhance 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 backfire. Ultimately, you’ll need 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 little more. Or, if you’re buying bonds, TIPS and their inflation protections may deserve a place in your portfolio.
Which sectors should you watch?
As for stocks, some will perform better than others in an inflationary environment. As an investor, it is important to keep an eye on a few key sectors. Be sure to check out Q.ai investment kits designed around specific investment areas, such as energy, inflation-resistant, or growth stocks.
The energy sector is closely linked to the consumer price index. The price of fuel, gasoline, electricity and natural gas as a public utility directly influences the CPI. Since the CPI is a key measure of inflation, the correlation is clear.
When energy prices rise or fall, the CPI is affected. With this, the energy sector is poised to do well as the economy faces inflationary pressures. This is because consumers generally cannot skip buying the energy needed to function in society. For example, even if the price of gas is high, many people still buy their usual amount because they simply need to get around.
Consumer staples such as groceries tend to do well when there is inflation. The reality is that shoppers have yet to collect their weekly supply of bread, eggs and milk. Even with higher prices, many families are forced to spend more on basic items found on grocery shelves across the country.
That’s why investing in core stocks is a good way to hedge your bets against inflation.
Growth stocks tend to have minimal cash flow. When times are good and inflation is manageable, growth stocks can soar. But when the economy hits hard times, consumers are forced to make changes in their spending just to make ends meet. With these budget cuts, it is harder for businesses without an essential service offering to survive.
Growth-based stocks will have a harder-than-average inflationary impact, so keep that in mind when setting up your investment portfolio.
Some investments are better suited to tolerate an inflationary environment than others. As the US economy settles into inflationary times, it’s important to keep a close eye on your portfolio. But it’s usually not the right time to enact major changes unless your portfolio is diversified enough to weather the coming storm.
Download Q.ai today to access AI-powered investment strategies. When you deposit $100, we’ll add an additional $50 to your account.