How Does Inflation Affect Investment Returns

Investing can be an unpredictable process. You can follow trends, analyze data, and make educated guesses on where your money is going, but constantly shifting markets and monetary factors can throw your investment strategy for a loop. 

One of those monetary factors is inflation. During a high inflationary period, investing can be slightly more challenging as earnings and real value becomes more volatile and hard to predict. Inflation can sometimes create uncertainty in a space where predictability is often rewarded.

Understanding how inflation can affect your investment returns and what to do about your investments during a high inflationary period can set you up for success in the long run.

Understanding Inflation

Inflation is an economic phenomenon that causes an increase in prices across most, if not all, goods and services. Many people often notice inflation when they visit the grocery store, for example, and see the price of eggs or bananas has risen.

Inflation isn’t necessarily a bad thing. The Bank of Canada targets a 2% inflation rate since low, controllable inflation helps the Canadian dollar retain its value. Stable inflation also helps individuals plan their spending and savings. However, higher inflation rates can negatively affect the economy and cost of living.

High inflation decreases the general population’s purchasing power. As the cost of goods increases, consumers can’t purchase at a higher volume. Dollars don’t go as far during an inflationary period as they would during others. 

Increased inflation rates can have widespread effects on the stock market. With less general purchasing power, companies may see diminished revenue, which can impact their value when it comes to earnings season.

Controlling Inflation

Inflation is often controlled through interest rates. An interest rate is the cost of borrowing—the rate is what you are charged for borrowing money as a percentage of the borrowed amount. The Bank of Canada sets a certain interest rate based on its economic data. 

You may have heard the term “cooling the economy”—that refers to raised interest rates. Central banks like the Bank of Canada may increase interest rates in response to inflation. The goal behind raising interest rates is to discourage spending throughout the economy.

Inflation & Your Portfolio

Inflation risk refers to the exposure of your investments to the inflation rate. In many cases, the higher your inflationary risk, the higher chance it can diminish your investment returns through a lack of purchasing power. 

There are 2 ways of measuring your investment returns:

• Nominal rate of return refers to the investment return without accounting for inflation.
• Real rate of return takes inflation into account by adjusting it to subtract the inflation rate.

The real rate of return takes your investment return’s purchasing power into consideration. It’s crucial to consider the real rate of return when measuring your investment returns since it more accurately describes the true value of your portfolio.

Setting Up Your Portfolio for Success

Beware of Bonds 

Bonds are generally considered risky investments during inflationary periods. They’re fixed-rate investments and carry a nominal interest rate that doesn’t adjust. That means the same amount is dispensed with each interest payment.

Because of inflation’s effect on purchasing power, the interest payment return doesn’t have the same value as it would during a period of expected inflation. If the inflation rate is higher than the bond’s interest rate, the income from the bond isn’t keeping up with inflation or the cost of living.

Find Opportunities for Growth

When it comes to inflation and your portfolio, look for growth opportunities. Stocks hold up better than bonds during high inflation; however, you should still be wary when making your investments. 

Value stocks may be a more prudent option during a high inflationary period because of the general population’s diminished collective purchasing power. On the other hand, growth stocks are a more lucrative option during periods of low inflation.

Diversification Is Key

To protect your portfolio from inflation, recession, and other economic phenomena, try to diversify as much as possible. Investment in only 1–2 industries can increase your exposure to inflationary pressures. Make sure you invest in multiple sectors to mitigate inflation risk and reduce the impact of more significant economic events.

Get Actionable Investment Advice

Making sense of inflation, rate of return, and purchasing power can be daunting when it comes to your investments. A financial advisor can help you navigate through the markets and help educate you on how to ensure your money can go further and help you achieve your life goals.

Get in touch with us at Qopia Financial or check out our resources to find the support you need.

Qopia Investments is a trade name of Aligned Capital Partners Inc. (ACPI). ACPI is regulated by the Investment Industry Regulatory Organization of Canada (www.iiroc.ca) and a Member of the Canadian Investor Protection Fund (www.cipf.ca). Qopia Investments is registered to advise in securities and mutual Funds to clients residing in Alberta, Ontario, Saskatchewan, and British Columbia. This publication is for informational purposes only and shall not be construed to constitute any form of investment advice. The views expressed are those of the author and may not necessarily be those of ACPI. Opinions expressed are as of the date of this publication and are subject to change without notice and information has been compiled from sources believed to be reliable. This publication has been prepared for general circulation and without regard to the individual financial circumstances and objectives of persons who receive it. You should not act or rely on the information without seeking the advice of the appropriate professional.

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Investment products are provided by ACPI and include, but are not limited to, mutual funds, stocks, and bonds. Non-securities related business includes, without limitation, fee-based financial planning services; estate and tax planning; tax return preparation services; advising in or selling any type of insurance product; any type of mortgage service. Accordingly, ACPI is not providing and does not supervise any of the above noted activities and you should not rely on ACPI for any review of any non-securities services provided by Qopia Financial.

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