Inflation is a pervasive but regular economic occurrence that weakens purchasing power. It causes concern among policymakers, businesses, consumers, and, of course, investors. When efforts to cool demand and reduce prices — like hiking interest rates — are too swift or drastic, an inflation can even contribute to triggering a recession. While several factors can cause inflation — such as a fall in the value of domestic currency or a demand–supply imbalance — its impact creates a hostile environment for generating positive returns, a key issue for all investors. One safeguard is to thoughtfully curate a portfolio of investments that have the potential to weather a period of inflation. This is easier said than done, especially considering that investment products are marketed based on absolute returns, without factoring in the rate of inflation. So, it falls upon the individual to select asset classes that might cushion the blow of rising costs.
While planning an investment portfolio to curb potential losses during a period of inflation, it’s best to consider assets that can sustain the sudden increase in the cost of living. For instance, if the inflation rate is over 10%, your investment should offer returns of at least 10% after tax deduction just to keep pace. The idea is to be able to save or reinvest a part of your returns, even during a period of inflation.
It is imperative to curate a portfolio keeping in mind your financial goals and personal milestones — and how a setback during inflation can impact your investments as well as other aspects of your finances, and consequently, affect how long it would take to achieve these goals. Inflation is generally a short-term concern, unless handled poorly by policymakers or recklessly by individuals. While there is an escalation in costs, it is temporary and can be managed by defining your goals, diversifying your investments, and choosing assets that can support you through an inflation.
A balanced asset allocation is ideal to prepare for a period of inflation. Based on your capacity for risk, this could be a mix of tangible assets like real estate and non-tangible options like inflation-indexed bonds, real estate investment trusts (REITs) or securitised debt instruments. For those who lean towards equity, investments in sectors like fast-moving consumer goods (FMCG), banking, utilities, energy and telecom, as well as value stocks — which are typically traded at a price lower than their worth — and gold exchange-traded funds, are likely to perform well during inflation.
On the other hand, growth stocks — which are otherwise preferred for their tendency to outperform in the long run but yield low returns during inflation because of a loss of momentum — as well as depreciating assets like cars, and investments in metals, may not yield satisfactory returns during this phase. Some may wish to reassess their investments when the market is volatile, to take advantage of the opportunities that do arise from the situation but also compensate for inevitable losses. Equity investors may underperform in the shortterm and eventually make up for lost time, whereas those exposed to bonds may outperform in the short term but plateau in the long term.
Besides creating a hedge against inflation for your investments, there are also steps to be taken to protect other elements of your finances. One of the most common mistakes people make when trying to cope with inflation is to sacrifice their investments when they should be managing their expenses. Expenses need to be curtailed to a reasonable extent as the prices of essential commodities shoot up and affect budgets. Since interest rates on loans and insurance cover do rise during an inflation, it is advisable to avoid taking on liabilities until it tides over. To pay off existing liabilities, consider refinancing your loans or liquidating assets that are likely to underperform due to inflationary pressures.
Inflation has a tendency to shift a person’s focus from investing for the long-term to seeking short-term solutions, driven by a sense of panic. It may trigger anxiety, herd mentality, or even overconfidence, all of which lead to hasty and impulsive financial decisions like shifting investments too frequently. Seeking professional assistance from qualified financial advisors on how to effectively manage your finances can prove helpful.
Once you have your fundamentals in place, it’s also important to stick to them. Patience and discipline help you sail through an inflation — remember that it is an unavoidable event in the cycle of economic development, and that it is not meant to last forever. In the long run, the rise in prices leads to more money flowing through the economy. Taking precaution simply allows you to stay on track for achieving your goals once recovery begins.