How inflation affects your investments

Summary

In this episode of 'How to Invest,' Julius Baer explores the concept of inflation and its impact on investments. The video explains both the positive and negative effects of inflation, such as its potential to stimulate economic activity, reduce debt burdens, and boost employment, while also eroding purchasing power and complicating business planning. Viewers learn how inflation affects different asset classes, particularly stocks and bonds, and discover strategies to protect their wealth. The video emphasizes the risks of holding cash during inflationary periods and offers insights into managing investments effectively in an inflationary environment.

Takeaways

• 😀 Inflation is the rise in the cost of goods and services over time, which means the value of money decreases. Central banks control inflation by adjusting interest rates.
• 😀 Inflation isn't always bad. It can stimulate economic activity as people spend more to avoid rising prices, contributing to growth and potentially boosting jobs and reducing unemployment.
• 😀 A moderate amount of inflation can reduce the real burden of debt, as the amount owed becomes smaller in real terms when prices rise.
• 😀 High inflation reduces purchasing power, meaning the same amount of money buys fewer goods and services over time. This impacts people trying to save or living on fixed incomes.
• 😀 'Core inflation' excludes volatile items like food and energy to give a clearer view of inflation, but this doesn't reflect the reality for individuals who feel rising prices in these categories.
• 😀 Businesses face challenges during inflation, as rising prices make it harder to plan for the future, set product prices, and maintain stable budgets, leading to potential instability in the economy.
• 😀 Inflation affects equity investments (stocks) by influencing company profits. Strong economies may allow companies to pass on price increases to consumers, while weak economies make this harder.
• 😀 Real assets, such as real estate and equities, are a good hedge against inflation. These tangible investments tend to increase in value during inflationary times.
• 😀 Fixed-income investments like bonds are vulnerable to inflation. If interest rates rise to combat inflation, the value of existing bonds may fall, especially if their fixed rate is lower than inflation.
• 😀 Cash loses value over time due to inflation. Even in interest-bearing accounts, inflation can erode the purchasing power of cash, making it a poor long-term storage option for wealth.

Q & A

What is inflation, and why is it important for investors to understand it?

Inflation refers to the increase in the prices of goods and services over time, leading to a reduction in the purchasing power of money. For investors, understanding inflation is crucial because it can significantly impact the value of investments, especially those involving cash, bonds, and fixed-income assets.

What are the differences between 'good' and 'bad' inflation?

Good inflation occurs when rising prices stimulate economic activity, boost jobs, and lower unemployment. It can also reduce debt burdens. Bad inflation, on the other hand, can erode purchasing power, increase costs for businesses, and reduce consumer demand, leading to economic instability.

How does inflation affect the purchasing power of money?

When inflation rises, the cost of goods and services increases, meaning that the money you have today will not buy as much in the future. For example, if inflation is 5%, you would need $10,500 to have the same purchasing power that $10,000 holds today.

What is core inflation, and how is it different from regular inflation?

Core inflation excludes volatile items like food and energy prices, which tend to fluctuate more drastically. By removing these factors, core inflation provides a clearer view of underlying inflation trends, though it may not fully reflect the real-world impact on consumers, who are still affected by rising food and fuel costs.

What impact does inflation have on equity investments like stocks?

Inflation can have both positive and negative effects on equity investments. In strong economies, inflation may boost company profits as consumer spending remains strong despite rising prices. However, in weaker economies, companies may struggle to pass on higher costs to consumers, which can lower profits and investor returns.

How does inflation affect the value of fixed-income investments like bonds?

Inflation erodes the purchasing power of the fixed income generated by bonds. When inflation exceeds the bond's interest rate, the real value of the income decreases. Additionally, higher inflation often leads to higher interest rates, which can reduce the value of existing bonds, making them less attractive.

Why is it better to own real assets during times of inflation?

Real assets, such as real estate or equities, are tangible investments that typically rise in value with inflation. These assets serve as a hedge against inflation, unlike cash or fixed-income investments, whose value tends to decrease over time as prices rise.

What are the risks of holding cash during inflationary periods?

Holding cash during inflation can lead to a loss of purchasing power over time. Even if you keep cash in a savings account with interest, the real value of that money may decline if the interest rate does not outpace inflation. For example, if the inflation rate is 3% and the savings interest rate is only 2%, the real value of your money is effectively decreasing.

How can inflation impact a company's debt and liabilities?

Inflation can affect both the assets and liabilities of a company. If the company owns property, its value may rise with inflation. However, inflation can also increase the cost of borrowing if interest rates rise, which can increase a company's debt burden and reduce profitability, potentially lowering stock prices.

What is the best strategy for investing during times of high inflation?

During times of high inflation, the best strategy is to focus on real assets like equities and real estate, which are better hedges against inflation. Additionally, if you're investing in bonds, it's often wise to buy shorter-duration bonds to reinvest at higher rates once inflation rises and interest rates increase.