Inflation, Inflation, Inflation. It is everywhere and potentially scary but fear not! Inflation is beyond your control, but that does not mean you cannot take action to help preserve your investments and savings from its effects. Many investors wonder how inflation impacts investments and how we can mitigate the effects.
Inflation can be a severe problem for both bond and stock investors alike. What is inflation? Our blog post goes into detail about what inflation is. But to summarize, inflation occurs when general price levels rise over time. Let us look at fixed-income investments and stocks.
Fixed-income investments
Fixed-income investments generate income for their investors by paying out a set interest rate. With regard to inflation, there is also the real interest rate—that is the rate of return adjusted for inflation. You will need to exceed inflation to maintain your purchasing power. The uncertain future inflation rates make your future real interest rate returns uncertain.
An exception to this rule is inflation-indexed bonds, such as the series I savings bond, whose interest rates rise to stay ahead of inflation. The current interest rate on I bonds is a whopping 9.62%!
Stocks work differently
According to market watchers such as Ibbotson Associates, stocks have historically outpaced inflation because of their unlimited earnings potential. When it comes to stocks, it is not easy to measure the impact inflation has on them because stock returns vary so much. But as a rule of economics, when inflation increases, the actual rate of return on stocks tends to decrease.
When building your portfolio, it is useful to plan for the effects of inflation on your investments. For this reason, many investors include investments in their portfolios to hedge against inflation.