How to Shield Your Portfolio from Inflation

In a stable economy, we expect prices to rise by a modest amount every year. The Bank of England and the US Federal Reserve target an inflation rate of 2% per year. At this level, businesses prosper, employment levels are high, consumer spending is positive and investors have more confidence.

But when prices rise too quickly, there are consequences. Essential goods and services become more expensive, and wages don’t always increase at the same rate. Household finances become stretched and unemployment can rise as companies look to cut costs.

Inflation is also one of the factors to take into account when constructing an investment portfolio.

How Inflation Can Affect Your Investments

High inflation can erode the real value of your money. If you have £10,000 in the bank earning no interest, an inflation rate of 4% means that it will only be worth £9,600 in a year’s time. Over a lifetime, this can result in significant losses when you adjust the value for inflation.

When investing, it’s important to consider the ‘returns above inflation’ as well as the monetary returns.

Most people want their investments to grow in value, as this makes the risk of investing worthwhile. But when inflation is taken into account, a return of 5% per year might only equate to 2%-3% in real terms.

In an environment where inflation sits at a steady rate of 2%, you will need to earn at least this amount in interest to avoid losing value. With interest rates at an all-time low point, it’s almost impossible to achieve this without investing at least some of the money.

Take Some Risk

To achieve investment growth above inflation, it is usually necessary to take some risk. This can be daunting if you have never invested before. But remember, inflation is also a risk, and by aiming for a no-risk portfolio, you are actually more likely to lose money in real terms. The longer the investment period, the greater the impact of inflation.

Taking a measured, appropriate amount of risk with your investments can increase returns. The key is to plan carefully, and avoid investing too much in one area.

Diversify Your Assets

High inflation can affect assets in different ways. For example:

• Cash loses value in real terms.
• Interest rates are usually pushed higher to make saving more desirable than borrowing and spending.
• Existing fixed interest securities will fall in value as the interest rates become less competitive and demand falls.
• Index-linked investments become more appealing and can rise in price.
• Asset-backed investments (for example, property or commodities) tend to hold their value, as their worth is based on something tangible rather than simply supply and demand.
• Companies producing basic necessities tend to thrive during periods of high inflation.
• Shares with high dividend yields increase in value, as generating an income becomes more desirable.
• ‘Growth’ shares may be lower yielding but have strong expectations of returns. Smaller companies and tech businesses often fall into this category. Growth shares tend to reduce in value during periods of high inflation, as their cashflow and income yields are not as steady.

So while we have a good idea of how inflation will impact different investment types, this is not necessarily a magic bullet in terms of deciding which assets to invest in. For example:

• Inflation rises and falls, and isn’t always predictable.
• The measure of inflation relies on historic price trends rather than a fixed moment in time.
• Inflation can vary on a global scale, meaning that UK and overseas assets are impacted differently.
• Inflation is one of many economic factors that will affect your investments.

The key is to invest in as wide a range of assets as possible. This means that if some of your investments lose money as a result of inflation (or for any other reason), others should increase, or at least hold their value.

Invest for the Long Term

Successful investing does not only depend on what you choose to invest in, but how long you invest for.

Statistically, a diversified portfolio or a multi-asset fund will increase in value. There will be some volatility along the way, but the longer you hold the investment, the more the peaks and troughs will even out. Aiming for a 5% annual return (or a 3% real return) does not mean the portfolio is likely to grow at this rate every year. It may lose 10% in year 1 and gain 17% in year 2. The end result is the same, but only if you keep your resolve and stay invested.

Plan your Income Strategy

If you are retired, or need to take an income from your portfolio, there are a few steps you can take to protect your funds from inflation:

• Plan withdrawals in advance so that you are not forced to sell investments during a downturn.
• Keep a cash buffer to cover any emergencies and planned spending.
• Make a budget and keep your spending under control.
• Withdraw the natural income yield from your portfolio before you dip into the capital.
• Make a cashflow plan so it’s clear how much you can afford to spend. This will need to be stress-tested, regularly reviewed, and adjusted as needed.

A financial adviser can help you work out how to achieve your goals, while taking inflation into account.

Please don’t hesitate to contact a member of the team to find out more about investment planning.