How inflation could affect your investments

All investments – from cash and fixed income securities to mutual funds, and stocks to cryptocurrencies – come with their own set of risk and reward characteristics. Understanding the relationship between risk and reward, and your individual comfort level with both, is a crucial part of building your investment portfolio.

Inflation risk is one type of risk that can impact your investments.

What is inflation?

Inflation refers to the rise in the price of goods and services over time. As prices rise, money doesn’t purchase as many goods and services as it used to because the cost of goods has increased or the value of the currency decreased. In either case, it erodes the purchasing power of your money over time.

Is Inflation good or bad for consumers?

Inflation itself is not necessarily good or bad as it depends on how fast and how much it rises. Rising inflation can be an indicator of a growing economy as it often translates to job growth and rising wages. As a result, some consumers may have more disposable income to spend on more goods and services. A moderate level of inflation is generally good for the economy, which is why the Bank of Canada’s target inflation rate is 2 per cent.

On the other hand, if the rate of inflation rises too quickly over a short time frame, consumers’ money quickly becomes worth less as the prices of goods rise more quickly than consumers can adjust to. Rapidly rising or volatile inflation can also be bad for corporate profits, as companies try to absorb rising costs and/or slowing sales. The Bank of Canada will often raise interest rates in these scenarios to cool an overheating economy and keep inflation within its target range. 

What is inflation risk?

“Inflation risk” refers to the risk of a loss of your future purchasing power if the value of your investments doesn’t keep pace with inflation.

There are two measures of your investment returns to look at:

Nominal rate of return – This is your investment return without taking inflation into account.

Real rate of return – This is your investment return minus the inflation rate. A “real return” does take inflation into account, showing the purchasing power of your investment.

If, for example, you hold fixed income investments yielding 3 per cent, and inflation is running at 2 per cent on average, your real rate of return is only 1 per cent. With the current interest rate environment at historical lows, even a small rise in inflation can have a significant impact on the purchasing power of your money. It’s important to look at your real rate of return during times of rising inflation.

How does inflation impact investments?

Inflation risk can impact all types of assets but is most relevant for bonds and other fixed income securities. For most investors, bonds are generally the most vulnerable to inflation risk because their payments are usually based on fixed rates. If the rate of inflation increases, the purchasing power of your bond payment decreases.

Stocks, on the other hand, may offer some protection against inflation depending on the type of company. Some companies can increase the price of their goods or services as inflation rises, so they can maintain their profit margins. However, inflation can negatively influence companies as they absorb higher prices and slowing sales can impact their revenue and profits.

On the other hand, some areas of the market may benefit from rising inflation, including commodities and commodity-related stocks, as well as real estate.

Inflation and interest rates

When inflation is rising quickly, central banks may respond by raising interest rates. With higher interest rates, the cost of borrowing rises which results in consumers borrowing and spending less. The same is true of companies, which may also invest less in growth strategies or cut spending. Companies that carry lots of debt may also be impacted as the cost of servicing that debt increases.  

On the other hand, some companies, like financial institutions like banks and insurance companies, may benefit from rising interest rates. 

How do I mitigate inflation risk?

When it comes to fixed income investments, there are a number of investment products that can address inflation risk, such as variable-rate investments. Their payments are usually based on an index that changes based on the rise and fall of inflation, such as the prime rate.

Inflation-linked bonds, the returns of which are tied to the cost of consumer goods, are another investment that helps to cushion the impact of inflation. The principal and interest payments of these bonds rise with inflation, helping to preserve your purchasing power.

Canadian real return bonds (RRBs) may also offer a hedge against inflation. However, unlike their U.S. counterparts, RRBs don’t offer deflation (the opposite of inflation, deflation is when consumer prices are declining) floors. That makes their holders susceptible to a capital loss at maturity if deflation persists. RRBs also typically have long maturities with some extending over 20 years. The longer the duration to maturity, the more volatile a bond becomes when interest rates fluctuate.

Managing inflation risk through diversification

The best way to mitigate the risk of rising inflation is to have a well diversified portfolio. If you’re investing for the long term, your portfolio should have a mix of different assets that suit your goals. If you put too many of your investment eggs in the bond and fixed income basket, you run a higher risk of a decline in your purchasing power over time if inflation rises.

A strong portfolio is one that is diversified across different dimensions. That may include holding different types of securities that are diversified between different sectors, markets, currencies and even countries. 

Having a well diversified portfolio with an asset allocation based on risk tolerance is the best defence against inflation. In most cases, inflation will be a short-term issue that should not impact or change your long-term investing goals.

Get a better understanding of how well your portfolio is positioned against different investment risks with Portfolio Score™, including credit, currency and inflation risks. Expand your knowledge of risk exposure by comparing your portfolio’s performance against domestic and global benchmarks.