Inflation, and how it 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.
One type of risk that can impact your investments is inflation risk.
Inflation is a concept most of us are familiar with. It refers to the rise in the price of consumer goods and services over time. As prices rise, your dollar won’t purchase as many goods and services as it used to. That’s what inflation does – it erodes the purchasing power of your money over time.
Want to see how inflation has affected the purchasing power of a Canadian dollar over the last 10, 25 or 50 years? Check out the Bank of Canada’s inflation calculator.
Inflation itself is not necessarily a bad thing. It depends on how fast and how far it rises. On the one hand, inflation can be an indicator of a growing economy, often translating to more jobs and rising wages. Consumers 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 rapidly, consumers’ money quickly becomes worth less than it used to be. Prices 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.
What’s 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.
The impact of inflation on investments
Inflation risk can impact all types of assets but is most relevant for bonds and other fixed income holdings. For most investors, bonds are generally the most vulnerable to inflation risk because their payments are usually based on fixed interest 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 because many companies can simply increase the price of their goods or services in response. However, inflation can negatively impact corporate profits as companies absorb higher prices and slowing sales, which often causes share prices to dip. In addition, inflation is often accompanied by rising interest rates, which can negatively impact a company’s profits. With higher interest rates, the cost of borrowing rises and leads to consumers therefore borrow less and spend less.
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.
Investment products designed to address inflation risk
There are investment products that can address inflation risk, such as variable-rate investments. Their payments are usually based on an index that are affected by 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 this bond 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
But the best way to mitigate the risk of rising inflation on your investment portfolio is to diversify. If you’re investing for the long term, your portfolio should have a balance of asset exposures 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. Incorporating other asset types, like exposure to stocks, may help you combat inflation risk and its potential impact on your portfolio. And while stocks are more volatile than bonds, and are prone to different risks, over the long term, historically on average, stocks consistently outperform both their fixed income counterparts and, importantly, the rate of inflation. (Past performance is not indicative of future results.)
Get a better understanding of your 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.
Ontario Securities Commission, Get Smarter About Money, Inflation. Accessed at https://www.getsmarteraboutmoney.ca/invest/investing-basics/understanding-risk/inflation/ June 2021.
Halton, Clay, Investopedia, “Inflationary Risk”, April 30, 2021. Accessed at https://www.investopedia.com/terms/i/inflationrisk.asp Jun 2021.
The information contained in this article was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete. This material is for informational and educational purposes and it is not intended to provide specific advice including, without limitation, investment, financial, tax or similar matters.