Inflation is a word we often hear in the news and during budget speeches. Inflation refers to the sustained increase in prices of goods and services in an economy or the increase in the cost of living over time. Many people may understand the concept and know what inflation is but may not truly grasp how inflation affects their investments.
Inflationary risk is the risk that inflation will undermine an investment’s returns through a decline in purchasing power. Simply put, in a rising inflation rate environment, the same amount of money in the future will allow us to buy less goods than today. When measuring the return of your portfolio one should analyze what we call the real return. The real return on your investment will take into account the actual return minus the inflation rate.
While inflation can affect all asset classes it is especially significant to investors who hold fixed rate bonds because the coupon payments are fixed. Investors who depend on their bond coupon payments, to supplement or act as income, are the most vulnerable- as the rate of inflation increases, the purchasing power of their bond payments decreases.
So how can an investor position their portfolio while managing inflation risk? Firstly, investors should remember their financial goals. It is never wise to have a knee jerk reaction to market volatility. They should assess their portfolio to ensure it still aligns with their goals and only make small adjustments where needed. Diversifying your portfolio so that all your eggs are not in one basket is another key element of managing inflation risk. Bond holders should also consider holding shorter term bonds in their portfolio to reduce interest rate risk. This is because rising inflation generally leads to higher interest rates. Shorter term bonds, especially those with a higher credit quality, are less affected by rising interest rates. Additionally, when they mature the funds can be redeployed to purchase newer bonds with higher interest rates.
In establishing an investment strategy, investors should plan for inflation. While we cannot avoid inflation a balanced portfolio will help mitigate against inflation risk and help investors to weather market volatility. As always, seek advice from a reputable financial planner when making your investment goals.
Christine Rankine is the Manager -Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm
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