Inflation and Your Investments
Effects of inflation in light of the recent spike
Understanding how inflation and economic swings affect the stock and bond markets is key to managing your portfolio strategically and controlling what you can control.
What Is Inflation?
Inflation is defined as an upward movement in the average level of prices. Each month, the Bureau of Labor Statistics releases a report called the Consumer Price Index (CPI) to track these fluctuations. It was developed from detailed expenditure information provided by families and individuals on purchases made in the following categories: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other groups and services.
How Applicable Is the CPI?
While it’s the commonly used indicator of inflation, the CPI has come under scrutiny. For example, the CPI rose 7.9 percent for the 12 months ending in February 2022. However, a closer look at the report shows price movement in more detail. Energy prices, for example, rose 25.6 percent during those 12 months.
Are Investments Affected by Inflation?
As inflation rises and falls, three notable effects are observed:
- Inflation reduces the real rate of return on investments. So, if an investment earned 6 percent for 12 months and inflation averaged 1.5 percent over that time, the investment’s real rate of return would have been 4.5 percent. If taxes are considered, the actual rate of return may be reduced even further. Your investments should be managed for their after-tax real rate of return.
- Inflation puts purchasing power at risk. When prices rise, a fixed amount of money can purchase fewer and fewer goods.
- Inflation can influence the actions of the Federal Reserve. If the Fed wants to control inflation, it has various methods for reducing the amount of money in circulation. Hypothetically, a smaller money supply would lead to less spending, which may lead to lower prices and inflation.
When inflation is low, it’s easy to overlook how rising prices affect a household’s budget. But, on the other hand, when inflation is high, it may be tempting to make more sweeping changes in response to increasing prices. The best approach may be to reach out to your financial professional to help you develop a sound investment strategy that considers both possible scenarios.