The prices of goods and services are constantly touching heights. This change in prices is known as inflation. One may not notice the price changes in daily purchases but when it comes to high-investment purchases including house, car, high-tech devices etc, inflation majorly impacts the purchasing power of an individual. One can also see the effects of inflation on their investments.

Let’s understand the concept of inflation and the effect of inflation on investment deeply.

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What is Inflation?

Inflation measures how the prices of goods and services, such as food, fuel, salon visits, and movie tickets, fluctuate over time. High inflation erodes the purchasing power of your money, meaning that the same amount of money buys fewer goods and services than it did before.

For example, if you could buy 10 items for Rs.100 in 2014, but only 8 items for Rs.100 in 2024, this indicates an inflation rate of 25% over those 10 years. While this might seem like a minor issue with a small amount, inflation has a significant impact on savings. The effect of inflation on investment impacts the bigger aspects of human life.

The primary goal of saving is to maintain or enhance your purchasing power, but with rising inflation, the value of your savings can diminish over time. Even substantial savings may not be sufficient if investment returns don’t keep pace with the increasing cost of goods and services.

Nominal and Real Interest Rates

These are two different types of interest rates one should be aware of, to understand the effect of inflation on investment

Nominal interest rate: It refers to the rate of interest without any adjustment for inflation. This interest rate would be earned only if the inflation is zero.
Real interest rate: It is calculated by subtracting the inflation rate from nominal interest rate. This shows your actual gain or loss in purchasing power, accounting for inflation.

Nominal interest rates need to be higher than inflation for investors to actually earn money. If the interest you earn on your investments is lower than the inflation rate, your real returns are reduced.

Cash and cash equivalents are also extremely vulnerable. When your cash isn’t earning any interest, inflation can reduce its value really quick. Without interest to counteract inflation, the purchasing power of your cash can decrease significantly.

Inflation vs Savings

Inflation has the potential to shrink your savings despite having a fixed interest rate through funds in savings accounts. In simple terms, inflation affects the worth of your retirement savings.

When you are working, make sure your earnings keep pace with inflation so the purchasing power exceeds, but when you are retired, inflation can diminish your buying power.

It’s crucial to keep an eye on inflation to make sure your savings will last through retirement. For example, if you need ₹45,000 a year to maintain your lifestyle now and inflation is 3% per year, you’ll need about ₹109,000 a year in 30 years from now to have the same buying power.

Inflation vs Fixed Income Investments

Fixed income investments include CD, treasuries, corporate or municipal bonds etc. Inflation can reduce the real returns on all these investments.

Investors purchase fixed-income securities to have a steady income through interest payments.

But, if inflation rate rises, the value of interest rate of these securities decreases as they stay the same until the bond matures. As a result, the price of bonds usually drops when inflation rises.

For example: Let’s consider a one-year bond with a ₹1,000 face value.

The investor buys the bond for ₹1,000 and will get this amount back only after one year.
Over the year, the investor will receive interest payments based on a 5% nominal interest rate.
With a 3% inflation rate, the real rate of return on this bond is only 2%, not 5%. This means the real value of the ₹1,000 returned at the end of the year is actually worth ₹970 in today’s money.

Rising inflation is more harmful to bonds that last longer since the purchasing power of upcoming interest payments is significantly reduced.

Inflation vs Stocks

The earnings or revenue of a company should technically increase at a comparable pace of inflation. In simple terms, the price of your stock should also increase if the general prices of consumer and producer goods are increasing.

Just like with fixed-income investments, high inflation can hurt your nominal returns on stocks too. For example, if your stock portfolio earns a 5% return but inflation is 6%, your actual return is negative.

When inflation is high, value stocks (companies that seem undervalued by the market) usually do better than growth stocks (companies expected to grow faster than average). On the other hand, growth stocks tend to perform better when inflation is low or normal.

Ways to Defend Your Portfolio Against Inflation

Following are a few inflation investment strategies you can follow to defend your portfolio against inflation:

Inflation-indexed securities: It includes bonds that are issued by the government or even companies, here the amount that is being repaid to you is adjusted for inflation. This protects the value of your investments and brings in higher returns than inflation rate.
Floating interest rate products: These investments have interest rates that fluctuate depending on the market conditions. When interest rates increase, the payments you receive from these products also increase. Central banks adjust interest rates as a tool to control inflation.
Commodities: Prices of certain commodities, like gold or oil, often rise with inflation. Investing in these can help protect against inflation.
Equity Income Funds: These funds invest in companies that pay dividends, which are regular income payments to shareholders. They can provide a steady income and potentially help keep up with inflation.

Inflation continuously impacts the value of money, affecting savings and investments. Understanding the difference between nominal and real interest rates, and how inflation impacts fixed-income investments and stocks, is crucial. To safeguard your portfolio, explore inflation-protected securities, floating rate products, commodities, and dividend-paying stocks.