How Inflation is affecting your Investments

There has been a fair bit of talk recently in the media about inflation, particularly rising inflation.

Firstly, when we talk about inflation, we are generally talking about the rise in the price of goods and services in any given economy. This is typically measured by the consumer price index (CPI) which measures the price of a basket of goods and services which are typically purchases by households. CPI thereby best reflects the price pressures placed on consumers.

So, if a basket of goods and services increases by 3% over a one-year period, we can say that consumer inflation is also 3% for that period.

The Reserve Bank of Australia targets an inflation rate of between 2-3% per annum and this is typically seen as being healthy in an economy as it shows the economy is growing at a sustainable rate.

So why do investors care about inflation?

Well, firstly, inflation can place an upward pressure on interest rates. Lenders seek higher compensation to lend their money, given it can now buy fewer goods and services when it is paid back in the future. Higher interest rates as a consequence can place downward pressure on the values of growth investments such as property and shares.

Returns on investments should be thought of in ‘real’ terms. The real rate of return is the nominal return less the rate of inflation.

As an example, if you invest into shares and earn 10% p.a. and inflation is 3% p.a., your real return is 7% p.a.

As this example shows, the higher the inflation rate, the higher the rate of return you need on investments to just break even.

As a result, higher inflation is generally seen as a negative for these types of investments as it results in higher borrowing costs, higher costs of labour and materials and reduced expectations on growth.

However, it is important to note that inflation doesn’t impact all investments the same. For instance, even during times of high inflation, we still need to eat. So, companies dealing in food are less impacted. The same holds true for healthcare, as we can still fall ill during these times.

Higher rates of inflation can present many challenges to investors, yet there are always winners and losers in any type of economic environment. As such, it remains crucial that your portfolio is well diversified and provides some exposure to investments which thrive during times of higher inflation.

If the current inflationary commentary has you worried about your investments, the Plus 1 Financial Planning team are here to help. Don’t hesitate to book a time with one of our Financial Advisers, Emma or Mason, which can be done via the links or by contacting the office via phone or email.