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Inflation is often called the “silent killer” of investments. This is because it erodes the “real value” of your wealth over time. Yet many investors fail to see the impact that inflation can have on a portfolio, and do not put measures in place to address it. In this article, our financial planners explain how inflation works, the ways it impacts investments and some implications for strategy.
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What is inflation?
Inflation refers to the rising cost of goods and services in an economy, overall, during a specific period (usually 12 months). The Bank of England (BoE) is largely responsible for inflation in the UK, and has a target of 2%. It tries to control inflation via the base rate.
Generally, the higher this base rate is, the more “downward pressure” on the inflation rate. This is because other UK banks set their own interest rates somewhere above the BoE base rate. So if rates go up, this creates more incentive for people to save. In turn, this tends to produce less consumer spending in the economy – acting as a “cooling effect” on inflation.
In 2022, however, inflation has hit very high levels. Currently, it stands at 9% – the highest rate in over 40 years. This is reflected in the rising costs of many household items (e.g. on supermarket shelves) as well as rising energy bills.
Rising inflation means that household incomes cannot stretch as far as before. This means less disposable income to spend on luxuries (e.g. digital subscriptions), and makes it harder to save and invest for the future.
How inflation affects an investment portfolio
There are at least two forces that act upon an investment portfolio when inflation starts to rise. Firstly, inflation itself erodes the value of your “real returns”. If your portfolio gains 10% in a year but inflation also rises 2%, then your actual gains (setting other costs and taxes aside) are 8%. However, if inflation hits 9% then the real return sits at 1%. This puts pressure on investors to turn to “higher risk” investments which hold out a higher possible return, although this may not be suitable for their strategy or risk appetite.
Secondly, rising inflation has, historically, put pressure on central banks (e.g. the BoE) to raise interest rates to try and control it. In the UK recently, for instance, the base rate has increased four times within 6 months (from December 2021 to May 2022) – now standing at 1%. This can put downward pressure on stock market valuations. In worst-case scenarios, it can encourage bear markets (a dramatic fall over 20%) as investors sell-off to access the better interest rates on offer from new government bonds.
Naturally, these dynamics have led many investors to worry about the state of UK inflation in 2022. What if things get worse and inflation rises to 10% (as the BoE predicts for the autumn), or even higher – as it did in the 1970s? It would be difficult even for “risk taking” investors to generate a good return in such an environment.
Moreover, if interest rates are likely to rise further and possibly lead to a market crash, should you get out of the markets now and hold in cash – ready to invest again when things “calm down”? These are understandable questions. Yet it is important not to make big decisions with your investments over what might happen. It is also vital to avoid emotional, impulsive choices out of a sense of fear or panic.
If you are concerned, consider speaking to your financial adviser. He/she will be able to hear your worries about your investments and help refer you to your long-term plan. Remember, you will have discussed the possibility of difficult market/economic conditions arising when you first put your investment strategy together.
Although the present situation is unfortunate, therefore, you likely accounted for such a scenario before you started investing. Bear in mind that you expected “hard times” to arrive, eventually, since this is the nature of stock markets. Over long periods, however, markets tend to recover their losses from short-term volatility and surpass their previous high-points. The S&P 500 is a good example. Since the early 1990s, the index has experienced dozens of crises including the 2008-9 Financial Crash and the 2020 Covid Crash. Yet, despite periods of bear markets and plateaus, it stands at just over 4,000 at the time of writing – up from 325 in 1990.
How should you react to rising inflation, therefore, as an investor? By and large, don’t. Instead, most people should stay invested, continue to contribute and take comfort from their long term financial plan. Speak to your financial adviser if you feel the temptation to act otherwise, and they can help you make wise choices that you will not regret later.
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