How Does Inflation Affect Your Investment Portfolio?

The recent inflation spike in July 2023 from 4.87% to 7.44% hurt all our wallets, raising prices across the market while sapping us of our purchase power.

As an investor, it’s likely that the thought of adjusting your investment portfolio crossed your mind. After all, you don’t want your investments to lose value in the face of skyrocketing prices.

But should inflation dictate how you invest? Well, here’s all you need to know.

The impact of inflation on your investment portfolio

Inflation will undoubtedly impact your investment portfolio. However, it affects different asset classes in different ways.

1. Impact on equities

Equities, or stocks/mutual funds, have a sort of love-hate relationship with inflation.

Modest inflation i.e Slowly climbing rate of inflation over a period of time ,usually in single digits; can be indicative of a growing economy, leading to higher corporate revenues and profits. In such scenarios, stock prices might rise.

However, runaway inflation, indicated by an upward price spiral, can increase production costs, squeeze profit margins, and erode consumer purchasing power. This can lead to declining corporate earnings and, subsequently, dropping stock prices.

2. Impact on fixed-income instruments

When you invest in fixed-income securities, such as bonds or fixed deposits, you’re essentially lending your money to the issuer. For your money, the issuer pays you a fixed income in return as interest. When the deposit matures, you get the original amount back.

These instruments are particularly susceptible to inflation. Say you park Rs. 1,00,000 in a fixed deposit that pays 6% interest, but the inflation is 7%. In such a situation, inflation has outpaced your investment. So, when it matures, your Rs. 1,00,000 would have depreciated in value due to inflation.

This is why inflation-indexed bonds were introduced. These bonds adjust their principal value with inflation, ensuring you don’t lose any money.

3. Impact on alternative assets

Real assets like real estate and commodities often act as inflation hedges, which means that in times of rising inflation, the value of these physical assets tends to increase.

For example, during inflationary periods, the price of gold—a classic store of value—often appreciates. Similarly, rental incomes from real estate might increase with inflation, making it a potentially resilient asset class.

4. Impact on international investments

Although India’s market is currently facing inflationary pressures, it doesn’t have to be the same for other countries. There is a possibility that an international market might be thriving.

This makes foreign investments a great opportunity to keep pace with inflation. However, it also comes at increased risk.

Can inflation be suitable for your investment portfolio?

Inflation can benefit certain investments and asset classes as the asset prices rise due to inflation. However, hyperinflation can cause worry, as it can affect consumer demand. It can lead to a decrease in consumer demand and spending, which will factor in company earnings forecasts and impact their stock value.

When inflation is high, stock investments are considered favourable investments as a rise in price also prompts companies to increase the prices of their goods. Then, if the demand for a product is inelastic, it can result in higher earning potential for the company.

However, lower consumer demand and lower earning forecasts due to hyperinflation can negatively affect stock prices in the short term.

To protect your investment portfolio against inflation

Here are a few investment options to get inflation-adjusted returns-

• Floating interest rate investments- The coupon payment rate falls or rises with the changing interest rates. RBI typically uses interest rates as a tool to control inflation. Plus, when interest rate increases, bond prices fall, and vice versa.
• Commodities- Certain commodities like gold and oil are also a good hedge against inflation as these prices increase with inflation.
• Equity funds- You can also consider equity income funds as funds invested in companies that can give you income in the form of dividends.

Inflationary investing–what you should do

In the short run, inflation can increase wages and, thereby, purchasing power. In fact, it can prove to be beneficial if the underlying economy is strong enough. But if the inflation continues to persist, it’s best to park your funds in safe companies and deposits to weather the storm.

You can also continue investing in equities. But make sure to target industries that fare better during inflation.

For instance, energy sector companies perform better during inflation than, say, a tech company. Why? Because their costs are tied to inflation. Consumers can avoid buying an iPhone but can’t avoid paying their utility bills.

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FAQs

How does inflation affect stock investments?

Inflation can raise input costs for companies, reducing profit margins. However, some businesses pass these costs onto consumers, leading to higher revenues. During inflation, the central bank also increases interest rates, which erodes the market liquidity and can reduce stock prices.

Is it good to invest during inflation?

Investing during inflation can be beneficial if you choose assets that tend to appreciate. Diversifying into inflation-resistant investments helps preserve purchasing power and maintain returns.

What is the effect of an increase in investment?

An increase in investment can boost economic growth by stimulating production and job creation. For individual investors, increasing investment during inflation helps maintain or grow the value of their portfolios by capitalising on inflation-resistant assets.

What is the effect of an increase in the current price of an investment?

An increase in the price of an investment can signal higher demand, potentially boosting returns for existing investors. However, new investors might face lower returns if they buy at inflated prices.