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When you invest your money, there are many different factors that impact your return—one of which is inflation. As prices increase over time, the purchasing power of your income and investments decreases.
In times of high or rising inflation, you may wonder what's the best way to direct your investments to minimize the negative impact. Here's what you need to know.
How Does Inflation Affect Investments?
Inflation refers to the general increase in the price of goods and services in an economy over time. These rising prices can have a negative impact on the money you have stashed in your bank accounts, certificates of deposit, retirement accounts, brokerage accounts and more.
In fact, when investment experts calculate the rate of return on a portfolio, one of the figures they calculate is the real rate of return, which is your return adjusted for inflation.
Inflation is natural, and, historically, the U.S. has averaged an annual rate of inflation near 3% over the past 100 years or more.
But in the short term, inflation can fluctuate, sometimes dramatically. In 2020, for instance, the inflation rate in the U.S. was about 1.23% compared with the previous year. In 2021, monthly inflation rates—how much the prices of certain consumer goods and services increased since the same month in 2020—have exceeded 5%.
As inflation increases, many investors may be unsure of whether they should change their portfolio's asset allocations. But while there are some investment options that work better during an inflationary environment, it isn't always necessary to make changes.
Which Investments Protect Against Inflation?
During times of high inflation, it's important to keep your goals in mind. For example, if your investment goals are short-term, you may not need to worry much about how inflation is impacting your portfolio.
If you're investing for the long term, inflation can have a larger impact on your portfolio if it's sustained—though high inflation that only lasts for a short period may end up only being a blip on your investment journey.
That said, here are some potential investments that can help protect your gains against inflation:
- Stocks: The average annual stock market return over the past 100 years is close to 10%, so while inflation can reduce the real value of your gains, you'll likely still end up with growth in the long term.
- U.S. Treasury Inflation-Protected Securities: Called TIPS for short, these Treasury bonds are indexed for inflation. Regardless of how high inflation goes, the principal value of your investment is adjusted accordingly, so you don't end up losing money.
- Short-term bonds: While short-term bonds may not offer the best return when inflation is high, the impact on your return won't be as drastic as it will with long-term bonds. Short-term bonds also give you more liquidity, and because they mature relatively quickly, you can easily reinvest in higher-interest bonds.
- Real estate: Real estate investments can do particularly well during high inflation periods because their value may increase along with consumer goods and services. If you don't have the cash to buy an investment property, you can invest smaller amounts via real estate investment trusts (REITs) or mutual funds that invest in REITs.
- Commodities: Investing in commodities like oil, precious metals and agricultural goods is typically a good way to hedge against inflation because their prices tend to increase along with consumer goods and services.
- Cryptocurrencies: Digital assets like Bitcoin can be extremely volatile, so it's generally a good idea to invest with caution. In the short term, though, some experts believe it could act as a hedge against inflation.
Depending on how much money you have to invest, these are investment options to consider. If you don't have a lot, for instance, buying crypto assets may not be the best choice because of their volatility. In some cases, it may make more sense to put your money into exchange-traded funds and mutual funds that invest in these types of financial instruments because they provide an easier way to diversify your holdings.
Pros and Cons of Investing for Inflation
Just as there are benefits and drawbacks of different investment options during normal times, the same holds true during periods of high inflation.
The biggest pro of investing for inflation is that certain inflation hedges can help you preserve the value of your portfolio and maintain the buying power of your gains. Diversifying your portfolio can also help reduce your exposure to risks unique to different types of assets. On the flip side, some of the investments that can help hedge against inflation carry more risk.
The important thing to keep in mind for long-term investing is that it's rarely a good idea to allow short-term conditions to alter your strategy too significantly. While it may be worth it to make some small changes, going overboard could result in you taking on unnecessary risk and straying too far from your long-term strategy.
Before you consider making big changes to your investment portfolio, especially if it's to long-term investments like those in a retirement fund, consider working with a financial advisor who can help you find the right strategy based on your financial situation, risk tolerance and goals.
Investing for the Long Haul
Investing for the long haul is a lot different than investing for short-term goals, so it's important that you have a set strategy in place. Here are some general tips that can help you succeed with your long-term investments like retirement, education planning and more:
- Avoid allowing short-term economic conditions to change your strategy too much.
- Develop an investment strategy based on your risk tolerance and financial goals, and stick with it. Keep in mind that your risk tolerance may and probably should change over time and as you get closer to retirement.
- Review your strategy and investments regularly and make small adjustments as needed.
- Avoid trying to time the market. Instead, use dollar-cost averaging to soften the impact of short-term market volatility.
- Diversify your portfolio across multiple assets to avoid putting too many eggs in one basket.
- Make sure you understand and limit costs, such as mutual fund fees or the percentage an investment manager may charge to manage your portfolio.
- Consider consulting with a certified financial planner—even if you plan to manage your portfolio on your own—to get advice about your strategy and how you can improve.
As you take steps to hone your approach to long-term investing, you'll get more comfortable not only with your decisions but also with short-term volatility in the market and economy.