How to Invest During Periods of High Inflation

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Investing when inflation is a concern usually leads to a more volatile marketplace. Not only is inflation a pernicious profit-erasing force, it’s also highly misunderstood by investors. Inflation and uncertainty seem to go hand-in-hand, but investors who understand what inflation’s real impact is could find themselves taking advantage of big opportunities.

On the surface, inflation is a relatively easy concept to understand. It dilutes the value of the dollar over time, so purchasing power goes down as a result. The only real way to combat inflation is to earn a return in excess of the rate of inflation. There are several ways to accomplish this, and it all depends on how high the inflation is and how fast it’s rising.

Inflationary investing

Inflation’s impact on the stock market is somewhat mixed. One of the first things inflation does is cause interest rates to rise, which in turn negatively impacts bond prices. Normally bond prices and stock prices are positively correlated, so one might think that when bond prices go down, stocks should as well. But in practice, this relationship doesn’t always work.

Historically, inflation seems to have no obvious effect on stocks. Companies seem to be able to absorb the impact of higher rates quite well and don’t suffer any long term damages, although some short-term volatility can happen. This non-impact seems counter-intuitive, given that inflation and higher interest rates also mean higher rates on business loans and other financing operations, which slash total earnings.

However, inflation also means that the economy is strong. A healthy, growing economy, even with rising inflation, can often be more beneficial to stocks than the negative impact higher rates have. A steady increase in inflation can actually be a good thing for stocks, but a quick rise can be devastating.

If inflation rises too quickly, companies aren’t able to adapt as well and earnings suffer more than expected. Purchasing power rapidly diminishes and the danger of stagflation – an environment that combines high inflation with low growth – becomes more likely. This can lead to a long-lasting detrimental effect on an economy, such as Japan’s economy during the late 80’s and all through the 90’s.

One of the most common hedges investors turn to when inflation is rising is gold. Because the precious metal isn’t tied to any currency, it tends to hold its value quite well, regardless of inflation. But gold only works as a hedge if the rate of inflation is higher than the rate of return investors can earn elsewhere. If interest rates are able to keep up with inflation, then gold loses its appeal, since investors can easily keep up with relatively risk-free assets like treasuries. It’s only when interest rates aren’t able to keep pace that gold’s value really shines through.

Diversification is always a good idea for investors, but during periods of high inflation, a diverse portfolio could be the best protection you have. The careful dance between inflation, stock returns, interest rates and commodity values means casting a wide net ensures you’re taking on as little risk as possible. Gold is the best choice when inflation is rising faster than interest rates can keep up with, otherwise a diverse stock portfolio is the best way to handle an inflationary market.