Inflation is the gradual erosion of the spending power of your money, as a result of a falling value in the absolute value of each pound in your pocket. Causes of inflation are numerous. They include; supply constraints, excessive money-printing by central banks, and a booming economy. Modest inflation can be easy to ignore, but over the long term, inflation has a seriously detrimental impact on the true value of your savings and investments. This article will explain how to protect your investments from inflation.
How much damage does inflation wreak on your assets?
Here is a summary of the inflation rates in the UK over the last decade:
|Year||Inflation Rate (CPI)|
Over the decade from 2011 to 2020, inflation has averaged at 1.98%. That exactly matches the Bank of England’s inflation target of 2%.
But before we share a job well done, let’s consider the cumulative effect this creeping inflation has on the spending power of money in the bank or investments.
On average, an which cost £1 at the start of the decade would cost £1.26 in 2020. That means that inactive money down the back of the sofa would have lost approximately a quarter of its value in that time.
This gives you a clear idea of the scale of the problem, particularly when investing for retirement or other long term goals. Your savings & investments needed to return 26% over this period just to tread water.
Now consider the low rates of interest available on savings and current account cash. At the date of writing, the best instant access account available on offer is just 0.67%. If you are prepared to lock your money away for 5 years, you can be offered up to 2%.
If inflation averages 2% per year, any savings account offering a rate of return below this could lose the race with inflation and actually buy less in the future than today. That’s not how savings are supposed to work, right?
This toxic combination of stagnating interest rates and higher inflation has a name: stagflation. However, even in more ideal times, the interest on cash is unlikely to exceed inflation by any significant margin.
A realistic mindset to adopt is that any money kept in cash will probably keep up with inflation if kept in a market-leading fixed-term savings account. But grow in real terms they will not.
So how can we better protect our investments from inflation? Let’s look at the options available:
How to protect investments from inflation
There are two strategies for combating inflation:
- Beating inflation
The first strategy is simply beating inflation through brute force. It’s about investing in assets with a higher expected return than inflation and aiming to maximise your real return. In the race between the incremental effect of returns and the detrimental effect of inflation, it’s making decisions to ensure that your horse will stay ahead.
- Linking to inflation
The second strategy is to invest in products or assets which directly link their prices to inflation indices. This means that when inflation is high, your asset return will increase and vice versa. Inflation-linked products are scientific hedges against inflation.
- Benefiting from inflation
The third strategy is to invest in real assets which will naturally rise in price in line with inflation. When the tide rises, all boats in the harbour will rise with it. If you choose to invest in real physical assets, their prices should also rise as the value of pounds fall. This becomes a natural hedge against inflation.
Let’s examine each of these strategies in turn:
Protecting your investments from inflation by seeking to beat it
The core principle of ‘beating’ inflation is that you won’t mind its effects too much if you still grow the spending power of your money.
Experienced investors aim to earn the historical average return of equities which is 5% per year. Given that inflation runs at 2% on average, this implies investors need to earn 7% per year in cash terms to deliver that real return.
It’s important to note that overtaking or beating inflation doesn’t actually remove its effects. In the example above, an investor would still be 2% better off had the inflation not occurred. They would have enjoyed a 7% increase in their spending power rather than just 5% after inflation is taken into account. The aim of the game is to simply achieve your financial goals in spite of inflation, rather than by seeking to ‘avoid’ or eliminate its effects completely.
The best investment portfolios for retirement will usually hold a high allocation of equities and property and a low allocation of cash and bonds. This is done to maximise the return of the portfolio and beat inflation by as wide a margin as possible.
For wealthy families with aristocratic wealth, the impact of inflation and inheritance taxes can make or break the value of an estate. This is why the largest estates which still exist today tend to have large sums tied up in high-risk/high return funds which are managed by portfolio professionals. These investments include the best hedge funds, best listed private equity and best VCTs, but unfortunately, these complex products are off-limits for typical retail investors.
Protecting your investments from inflation by hedging against it
A small selection of investments and products exist that are designed to protect your portfolio against inflation. Examples of these clever products include:
- Inflation-linked government bonds
- Inflation-linked savings bonds
This means that the flat yield earned by bond investors each year should increase in periods of high inflation – helping to protect your portfolio from its erosive effects.
Because government bonds are priced in the market, you won’t necessarily receive 1:1 inflation protection, as the absolute yield to maturity of each bond will differ depending on the price you bought it for.
If you buy a government bond at its par value then this inflation hedge will work in quite a precise fashion. However, government bonds currently trade way above their face value due to the low-interest rates available elsewhere. This means that the change in the value of coupons may not fully compensate you for inflation.
That being said, the market pricing can come to your aid in another way. When inflation expectations increase, investors will place a higher value on index-linked bonds which will cause their value to rise. For investors already holding these bonds, this will provide a temporary capital gain that will further hedge against inflation. Beware as the opposite will occur when inflation expectations fall.
Inflation-linked savings bonds are very rare but do exist. National Savings & Investments operate an inflation-linked savings bond called Index-linked Savings Certificates. However, in a blow to savers, these were closed to new savers back in 2010 following extreme demand in the wake of the financial crisis.
Derivatives such as interest rate swaps & inflation-indexed derivatives can also be used to fight inflation, however these are not suitable for retail investors and therefore we won’t go into further detail in this article. If you’re interested in this subject area, please check out the best derivatives books to learn more.
Protecting your investments from inflation by buying real assets
Inflation is the increase in the price of goods and services. Therefore, one way to hedge against inflation is to invest in those same goods and watch their price appreciate over time with inflation.
An example would be investing in wine or investing in fine whiskey. If these products are affected by inflation, then the resale price of these assets should inflate over time simply due to inflation alone. Any extra appreciation in value due to the dated vintage would come on top of this inflation dividend.
Businesses themselves are also owners of real assets, and therefore some view equities as a ‘real asset’ although this is up for dispute.
Equities don’t tend to fare brilliantly during periods of high inflation because the actions taken by central banks to stem inflation tend to catch equities in the cross-fire.
The main lever that the Bank can pull is to increase interest rates. Doing so will raise the expected return of low-risk assets such as bank accounts. This improvement in the risk-return profile of safe assets results in more capital flowing out of risk assets, such as equities, and into cash.
If you read the best economics books and finance books, you’ll also learn about other models, such as discounted cash flow, which will also explain why the value of shares can fall when inflation (and interest rates) appears.
However, that being said. As we explained in the previous section, the absolute expected return of equities over the long term is usually more than enough to see off the risk of inflation, regardless of their short-term price performance during an inflation spike.
Investing in property is another popular form of real asset purchase which can protect against inflation. Although again this comes with caveats. Higher interest rates also dampen prices in the property market because this makes mortgages more expensive and therefore house buyers have less spending power when bidding up prices of their favourite house.
Overall: Inflation is a clear enemy of the investor, but you can win the battle
This article about how to protect your investments from inflation is not designed to replace financial advice. Please consider finding a financial adviser if you feel you need independent advice on your situation.
Overall, it’s actually quite easy to protect your portfolio from inflation using one, or all of these investment strategies.
If you build a basic investment portfolio that contains a good allocation of equities and doesn’t tie up much cash in unproductive savings accounts, you should expect a positive real return.
The exact weightings of your portfolio to the different asset classes will determine what level of a real return to expect, but this judgement should be subject to the usual thought processes on how much risk you’re willing to take.