Selecting investment portfolios that help provide protection against inflation
30 May 2022
It seems that everywhere you go these days the topic of inflation is never far away from people’s thinking. With Australia’s inflation rate hitting a 20-year high of 5.1% and the United States experiencing a historic rate of 8.5%, it's important to understand the impact that high inflation can have on investment portfolios and furthermore, the wealth management strategies you could be employing to help protect your portfolio against the effects of inflation.
What is inflation?
First, the nomenclature.
In simple terms inflation is the reduction of a currency's purchasing power where one dollar today buys more than it does tomorrow. For example, with a 5.1% inflation rate, a shopping trolley full of products costing $1,000 today will cost you $1,051 in one years' time, The concept is driven by supply and demand and, after two years of suppressed demand owing to global COVID-19 protocols coupled with resource shortages stemming from the Russia / Ukraine crisis, surging consumer demand and a scarcity of supply is resulting in price increases known as inflation.
How are investment portfolios affected by inflation?
So, what does inflation mean for investment portfolios? Basically, it means an erosion of the returns generated by your portfolio.
For example, a one year term deposit purchased for $10,000 with an interest rate of 1% p.a. will earn $100 in interest at the end of a twelve month period. After annual inflation of 5.1%, your real rate of return (rate of return minus inflation) will be minus $410, which makes your $10,000 initial outlay worth $9,590 in real terms after twelve months.
Essentially, inflation drains a financial instrument of its value, especially over sustained periods. Couple that with low interest rates like we've seen over the last few years, and you have an environment that yields minimal, or even negative real returns as shown in the example above.
Strategies to protect investment portfolios from inflation
Unfortunately, there's no silver bullet when it comes to completely hedging investment portfolios against inflation. It may seem like a well-worn concept but the best strategy to help manage the impact of inflation is to diversify your investment portfolio.
To protect your savings against erosion, you should look to include a mixture of assets into your overall portfolio, including shares in blue-chip companies, real assets such as real estate and infrastructure, alternative investments and floating rate bonds. Selecting the right assets in these categories can help to provide you with a buffer against inflation.
During a period of high inflation, traditional fixed rate bond funds will experience a fall in capital value in response to rising interest rates. Floating rate bonds on the other hand offer variable coupon rates that increase with official interest rates. Therefore, it’s important to make sure you hold some exposure to floating rate bonds within investment portfolios as these instruments can help provide portfolios with greater stability during periods of high inflation.
Gold, precious metals, and other commodities
Commodities have real-world value. That holds especially true for precious metals such as gold. Gold truly shines during periods of high inflation because it tends to retain its value despite external market factors. Unlike many other financial instruments, gold is not based on a fiat currency and therefore its valuation remains relatively consistent.
Commodities can be highly volatile and dependent on supply chain issues, but when you target a relatively stable commodity, it can help provide investment portfolios with a great hedge against inflation. While it is difficult to purchase most commodities directly, you can gain exposure to these assets via direct investment into mining stocks, or by investing in a managed fund that invests in a portfolio of mining companies.
Real assets such as infrastructure and real estate have historically performed well in periods of high inflation for several reasons. The income generated from these assets is generally tied to inflation and will therefore rise in concert with CPI. Furthermore, higher inflation typically reflects an economy that is experiencing growth in economic output. Resultant labour shortages and wage growth can stimulate consumer spending which benefits these real assets.
How to protect investment portfolios from inflation
So far, we've discussed the elements of healthy, inflation-resistant investment portfolios. Now let's discuss some industry best practices to keep your investments in good stead.
One last time for good measure: a diverse portfolio is the best weapon against inflation. It's equally important, however, that you review your portfolio regularly to make sure it is appropriately balanced and reflects your tolerance to investment risk.
It's easy to consider high level asset allocation when performing a review but don't forget to regularly review the underlying investments within your portfolio as well. This should encompass a review of the fees involved and the performance of investments relative to peers as a minimum, to make sure your returns are being maximised.
Final thoughts on protecting investment portfolios from inflation
We are now in a period of global inflation and Australia is in no way immune to the effects. Keeping investment portfolios balanced and working for you can be tricky under current market conditions. Sometimes the best course of action is partnering with the right financial services firm to meet your goals and objectives.
Findex provides investors with an end-to-end wealth management and investment solution. From regular reviews of your investment allocations, to audits of the investment managers responsible, we make sure we understand the tone of the global market, to help get the best possible return on your investments. In doing so, we make sure the right people are in the right positions to encourage your assets to grow. If they're not, we rotate to managers whose experience best matches your portfolio's allocation. And we always aggressively negotiate for lower rates on your behalf.