Opinion: The impacts of inflation

Inflation is at a record high. As Trading Economics found, the aggregate June 2022 inflation rate of 9.1% has not been higher since November 1981. But what does this mean for the investor?

Before diving into the ramifications of such high inflation rates, it is important to first understand what inflation is. Inflation is the rate at which prices for goods increase over a certain period of time; as prices increase, purchasing power – how many goods and services a single dollar can buy – decreases, according to Investopedia. In other words, the higher the rate of inflation, the more expensive goods are for consumers and the less they can buy with the same income.

Inflation is most commonly measured through a metric known as the consumer price index. The Bureau of Labor Statistics defines the CPI as a measure of the average prices that consumers have to pay for a select basket of goods and services.

But what exactly does the CPI contain?

The CPI aims to be representative of the goods and services that all U.S. consumers buy, so it includes around 94,000 price quotes. The Pew Research Center reports that at around 32.39%, prices for homes and rent occupy the largest portion of the CPI, with food, transportation, energy and medical services trailing behind at rates of 13.99%, 7.98%, 7.54% and 6.99%, respectively.

Over the course of the last year, many components of the CPI have risen dramatically, as can be extrapolated from the high inflation rates. In just 12 months, gasoline prices have risen by 59.9%, energy prices have risen by 41.6%, electricity prices have risen by 13.7% and food prices have risen by 10.4%, according to the Bureau of Labor Statistics. These rising prices have drastic effects on both consumers and investors.

For consumers, the main impact of inflation is the reduction in their money’s purchasing power. Consumers simply cannot buy as many goods and services with the same income as they used to be able to. For consumers living on fixed incomes, like retirees living off their savings or Social Security, inflation is even more lethal because there are no prospects of their income increasing, so the decline in purchasing power impacts them more significantly.

Similarly, inflation can affect investors in many different ways. For investors who bought fixed-income securities – such as bonds or certificates of deposit — hoping for stable returns, inflation eats away at their earnings; because the returns from these investments are constant, as prices rise, the purchasing power of the returns declines, according to the U.S. Bank. Consequently, the bond prices decrease as inflation rates increase, according to The Balance.

Furthermore, high inflation rates decrease investors’ real rate of return, which Investopedia defines as the annual percentage return, or the nominal return, adjusted for inflation, as well as taxes and any other fees. A heuristic method investors use to calculate their real rate of return is simply subtracting the inflation rate from their nominal rate.

So, how can investors protect themselves from rapidly rising prices and hedge their portfolios against inflation?

U.S Bank describes two strategies that have the potential to mitigate the effects that inflation has on investors’ annual returns.

The first strategy is diversification. If investors diversify their holdings among multiple industries and sectors, as well as between asset types — such as by owning stocks, bonds and real estate — then they can be more protected. For example, if bond prices plummet due to inflation, investors’ holdings in other asset classes might cover the losses incurred from their bond investments.

The second strategy is for investors who want a steady stream of inflation-adjusted income: owning Treasury inflation-protected securities. Since the returns on TIPS increase as inflation rises, their real rates of return remain constant and remain relatively unaffected by inflation.

However, while TIPS might be a hedge against inflation, investors should be careful when investing in them because they tend to underperform other securities when inflation rates are low and often have very low rates of return, according to Charles Schwab.

Although inflation can be detrimental to investors’ returns, there are ways to mitigate its effects.