Understanding Inflation: How Rising Prices Affect Investments and What To Do About It

With inflation still at high levels globally and traditional savings becoming worth less and less, you may be wondering about the impact of seemingly endless increases in the cost of living on the value of your investments. In this article, we’ll take a look at inflation to explore how rising prices affect investors and describe some strategies that many traders and investors use for risk management.

Inflation’s effect on stocks

There are many direct and indirect ways that high inflation can have an impact on the financial markets, but there are perhaps three that have the most significant effect:

Earnings erosion

When inflation is high, companies suffer as their costs for things like materials and labour increase. This can squeeze profit margins and reduce corporate earnings, meaning stock prices may stagnate or even decline as investors become less optimistic about future earnings.

Interest rates and bond yields

The remit of the Bank of England is to use interest rates to keep inflation under 2% so high inflation equals higher interest rates. Higher interest rates tend to make fixed-income investments like bonds more attractive compared to stocks, causing stock prices to fall as demand drops off.

Real returns

Even if your investments appear to be performing well, if they aren’t outpacing inflation then they’re actually giving you negative real returns. Adjust earning and investment growth for inflation to give you a realistic idea of the value of your portfolio.

How to manage risk in times of high inflation

There are things investors do to manage some of the risk associated with inflation. This can include basics like monitoring interest rates and central government and bank policy, as well as regularly reviewing and adjusting their portfolios.

Diversify your portfolio

This is the theory of ‘not putting all your eggs in one basket’ and means making sure you have a mix of investments across asset classes, including bonds, real estate, and commodities. This helps to mitigate risk – while some investments may do poorly due to inflation, others may perform better.

Trading vs investments

Another option could be to speculate on the FTSE 100 via CFDs (Contracts for Difference). FTSE 100 CFDs offer exposure to the performance of the UK’s top 100 companies without the need to buy and manage individual stocks. The aim is to see if you can profit from either rising or falling markets. However, they also come with high risk due to the use of leverage, so it’s important to have a good understanding of risk management strategies.

Inflation-protected securities

Consider investing some of your money into inflation-protected securities, such as inflation-linked bonds (ILBs). You might also want to look at commodities like gold, silver, or even agricultural products as these often have intrinsic value and can act as a hedge against inflation.

We’ve shown how high inflation can have a damaging effect on the value of investments, but careful planning, keeping up with market news and portfolio diversification can all help to mitigate the impact of inflation. Remember too that investing in stocks is a long-term plan, so try to keep a level head and look at the bigger picture during the short-term troughs.

When making any kind of financial decision it’s important to take appropriate professional advice and to know that the value of your investments can go down as well as up.