It’s been a few decades since we’ve experienced significant and prolonged high rates of inflation. Many investors today have not seen first-hand the damage higher prices can wreak across an investment portfolio.
For October, the official inflation measure in the US, CPI, registered its highest level in more than 30 years at 6.2%. If we measured inflation the same way we did in 1990, the October rate would be a whopping 9.9%.
We experience inflation as the rising cost of goods and services, from food to housing to petrol. But the effects of an inflation period can reach into your investment portfolio as well.
Inflation and its threat to share prices
Shares tend to be valued by investors who expect the underlying company to be able to earn more money in the future. This would make the shares they hold today potentially worth more at a future date.
Inflation, however, complicates that picture, because with rising prices the money the company earns in the future is worth significantly less (e.g. it buys less in goods and services). So, in inflationary times investors tend to be less willing to pay higher share prices in return for receiving money down the road.
As a result, many periods of high inflation have also been periods of declining share prices. In the high inflation years of the 1970s, share prices dropped by half and did not recover to their former levels for almost 6 years.
Inflation and its threat to bonds
On the other end of the investment spectrum we have bonds, which also tend to suffer in inflationary periods.
This is because inflation often prompts central banks to raise interest rates to cool the economy down. By making money more expensive to borrow (with higher interest rates), central banks try to calm inflation down to lower levels.
In this scenario, if you own a bond (or if a fund you hold owns a bond) that pays 3% interest, and another bond comes along that pays 5% interest, it means the 3% bond you own is worth less. As with shares, in the future when the bond (or bank deposit) matures and you receive your principal back, that money is also worth less in buying power.
Inflation and its threat to your standard of living
The third threat from inflation is probably the simplest to relate to.
Unless your earnings rise as fast or faster than the rate of inflation, your standard of living will go down. You might be earning the same amount as you always were, but you would be forced to buy cheaper food, take fewer vacations, and forego your favourite luxuries.
Some inflationary periods have also seen large increases in wages, which meant that living standards did not decline. When the prices of goods and services rise (as they are now) but wages do not rise quickly enough (as they are not rising now), it’s considered the worst-case scenario: so-called “stagflation”. Costs of goods rise quickly but the economy is not growing quickly enough to generate higher wages.
What investors and savers can do to fight back against inflation
A quick strategy when the prices of goods are rising is to own some of those goods!
Gold bullion is one such physical good connected to the real economy and has served as a way for investors to protect their wealth against rising prices for centuries.
In the high-inflation period of the 1970s for example, gold went from $35 per ounce to top out at $878 per ounce, a gain of more than 2300%.
While we can’t predict gains of that size going forward, we are entering a period when protecting wealth from inflation becomes a top priority. Rush Gold makes it simple to do!