How should this affect your investment portfolio?


Inflation is wreaking havoc on budgets across the country. With the Consumer Price Index (a key gauge of inflation) hitting its highest level in 40 years earlier this year, it’s an economic issue affecting all Americans.

As an investor, the idea of ​​changing your portfolio selections has probably crossed your mind. You might be tempted to make adjustments to combat this skyrocketing inflation. But should inflation influence your portfolio selections? Here’s what you need to know.

The impact of inflation on your portfolio

Like it or not, it looks like inflation is going to be around for a while. Although the Federal Reserve is trying to fight inflation with interest rate hikes, it will likely take some time to tame our current inflationary environment.

The CPI cooled slightly from July 2022. But if inflation is above 8%, everyone will continue to feel the effects. It’s inevitable that inflation will have an impact on your portfolio, but it can affect different assets in different ways. Here’s how inflation will affect stocks and bonds.

Shares

Stocks are considered more volatile investments than bonds. If you’ve been an investor for a while, you’ve probably noticed how quickly stock prices can go up and down. The past two years have been a particularly bumpy ride for investors with stock-heavy portfolios.

Although stocks are generally better positioned to keep up with inflation than bonds, not all stocks are able to compensate for skyrocketing inflation. For example, stocks in the energy sector can track inflation better than stocks in the technology sector. This is because energy costs are directly linked to inflation. Consumers may be able to live without the latest tech gadgets, but they can’t easily avoid paying for energy.

Obligations

Bonds are often seen as a more stable investment opportunity than stocks. The lower risk associated with bonds makes them more stable, but the lack of risk also leads to lower returns. And when inflation is running high, bonds often can’t keep up.

A problem with inflation for bond investors is that because bonds are debt-based, they’re usually locked into a specific interest rate. So when the Federal Reserve starts raising interest rates in an effort to fight inflation, the real yield on existing bonds drops.

However, there is an exception to this rule. Treasury Inflation-Protected Securities are bonds specifically designed to keep pace with inflation. After buying a TIPS, the principal will increase with inflation and decrease with deflation. Changes are made based on changes in the CPI and interest is paid twice a year at a fixed rate.

Alternative investments

Stocks and bonds are not the only investment opportunities. Many investors have a portion of their portfolio allocated to other types of assets.

Investing in real estate through income-producing properties or real estate investment trusts (REITs) gives your portfolio exposure to another sector of the economy. In general, real estate is believed to follow inflation, but individual factors in a local market could impact this trend.

Other investments that typically keep pace with inflation include precious metals and certain commodities, such as crude oil, natural gas, grains, and other agricultural products. Many investors choose to add gold or silver to their portfolio to hedge against inflation.

The downside to some of these alternative investments is that you might need more knowledge to get started. You may even have to commit to owning and protecting a physical asset, such as income-producing individual property.

Consider other markets

Inflation does not always impact markets around the world in the same way at the same time.

Although the US market is experiencing high inflation, not all countries have the same problem (or at least not to the same extent). Seizing the opportunity to invest in an emerging market is risky, but some foreign markets might give you a better chance of keeping up with inflation.

Should inflation influence your portfolio?

It is clear that inflation will have a negative impact on most investment portfolios.

The inflationary environment makes it difficult for assets to produce a positive return. After all, when inflation is above 8%, you’ll need investment returns of at least 8% just to keep up. It’s easier said than done.

It’s best to build a diversified portfolio along the way to minimize the impact of inflation on your returns. Here are some best practices to consider when building a portfolio designed to keep pace with inflation:

Define your goals

Inflation is a pervasive economic influence that eats away at purchasing power. When inflation is there, it impacts everyone’s funds. But you will have to decide for yourself what type of course you want to follow with your investments.

Everyone wants to avoid the impact of inflation. However, this is not the only factor to consider when building a portfolio. You will also need to determine the level of risk you are comfortable with. You can take more or less risk depending on your preferences.

To diversify

Instead of rushing through a ton of changes, start by assessing where your portfolio is. If you’re not already diverse, it might be time to make some changes.

The good distribution between equities and bonds is the first number to consider. As an investor, you will need to decide which ratio is best for you. Typically, investors with lower risk tolerance bolster their portfolios with more bonds, and investors with higher risk tolerance are comfortable with more volatile stocks in their portfolios.

But when it comes to intense inflation, having too much of your portfolio in bonds could actually backfire. Ultimately, you’ll have to weigh the volatility risks associated with the stock market against the exhausting power of inflation.

In the event of inflation, you could decide to favor equities a little more. Or, if you’re buying bonds, TIPS and their inflation hedges might deserve a place in your portfolio.

Which sectors should be monitored?

When it comes to stocks, some perform better than others in an inflationary environment. As an investor, it’s important to keep an eye on a few key sectors. Be sure to check out Q.ai’s investment kits designed around specific investment areas, such as energy, inflation-resistant or growth stocks.

Energy

The energy sector is closely linked to the consumer price index. The price of fuel, gasoline, electricity and natural gas as a utility all play directly into the CPI. Since the CPI is a key measure of inflation, the correlation is clear.

When energy prices rise or fall, the CPI is impacted. With this, the energy sector is poised to do well when the economy faces inflationary pressures. Indeed, consumers generally cannot do without buying the energy necessary to function in society. For example, even though the price of gasoline is high, many people still buy their usual amount because they just have to get around.

Staples

Consumer staples, like groceries, tend to do well when inflation is around. The reality is that shoppers still need to pick up their weekly supply of bread, eggs, and milk. Even though prices are higher, many families are being forced to spend more on basic items found on grocery store shelves across the country.

For this reason, investing in basic stocks is a good way to hedge your bets against inflation.

Growth stocks

Growth stocks generally have minimal cash flow. When times are good and inflation is manageable, growth stocks can soar. But when the economy is going through tough times, consumers are forced to alter their spending just to make ends meet. With these budget cuts, it becomes more difficult for businesses without essential services to survive.

Growth-based stocks will take a stronger than average inflationary hit, so keep that in mind when setting up your investment portfolio.

Conclusion

Some investments are better suited than others to tolerate an inflationary environment. As the US economy settles into a period of inflation, it’s important to watch your portfolio carefully. But now is usually not a good time to embrace major changes, unless your portfolio isn’t diversified enough to weather the coming storm.

Download Q.ai today to access AI-powered investment strategies. When you deposit $100, we add an additional $50 to your account.

Previous HGI: still offers an attractive long-term investment vehicle
Next How to Build Your Investment Portfolio 101