Tuesday, March 24, 2009

What is inflation and how does it affects your portfolio?

One of your most deadly enemy is certainly inflation. While the aim of your portfolio is to grow with time your first aim is to make sure that your portfolio is able to keep up with inflation.

So what is inflation and why is it so deadly?

Inflation can be defined as the increase in the price of goods, services, wages and natural resources. Simply speaking the price of everything that a person may want to buy increases with time as a result his salary will also tend to increase just to be able to buy the same amount of goods.

What are the effects of inflation on investors?

1. It decreases the real value or purchasing power of actual money. If the price of goods increases with time, then a sum of money will buy less and less volume of goods with time. As a result you will have to work hard to increase the value of your investments just to keep the volume of goods that you can buy constant. One of the first aim of any investors in is thus to be able to beat inflation. If you are unable to beat inflation then the real value of your portfolio , measured in the volume of goods that you can buy , will decrease with time.

2. It cause severe disruption to stock markets for investors will tend to buy stocks that give a return greater than the rate of inflation. Any stocks that is unable to beat inflation will be sold even though the company may be of sound health but is just suffering from a temporary setback. It just amplifies the sell off of stocks that is giving low return irrespective of sound fundamentals.

3. Bond that has medium and long term maturity and that has not been indexed to inflation will slowly lose value if inflation is greater than the interest rate on these bonds. People who have invested largely in bonds will thus sees their portfolio decrease in value with time.

4. Some stocks do badly in an inflationary environment. This is because increase in the price of raw materials is more difficult to pass to consumers in a competitive market. As a result this will drive the profit margin down. This will have a two fold effect on these companies. (a) it will make it difficult to give wage increases and (b) if wage increases are given then the dividends given to shareholders will drop causing a drop in the share prices of these companies.

As you can see the effects on investors and companies alike can be quite devastating. Even moderate inflation if compounded over a long time can be quite dangerous.

So what can be done to reduce the effects of inflation?

The best way to fight inflation is to be well invested with the long term in mind.
Although inflation decimate all investment categories over the medium term, the return over the long term tend to be greater than the cumulative effect of inflation. Also inflation do not affect all asset categories to the same extent.

A well diversified portfolio with the following asset class will make your portfolio inflation resistant.

1. Treasury bills and bonds
Although treasury bills and bonds suffer poorly in inflationary periods, they are able to maintain the value of the portfolio in time of stock market crash and deflation. Also even bills and bonds over the medium and long term have returns that exceed inflation.

2. Stocks
Stocks suffers less that treasury bills and bonds they have the highest possible return when considered over the long term. As a result a well diversified stock portfolio with stocks from different industries and different countries will resist well again inflation. Since inflation does not affect every country and industry the same way and at the same time.

3. Gold

Gold is a good inflation hedge. In inflationary times the value of gold rises to keep up with inflation. So it is a good advise to have a certain percentage of your wealth in gold. Beware however that gold only keep its value and offer no return.Hence your investment in gold will not increase in real value but merely keep up its value.

4. Commodities

It is known that the value of commodities increases in time of inflation, although some commodities will not behave this way. So if you are of the adventuring type, you can invest in commodities futures. I would however not advise any one to do so.

5. Real estates

It is well known that land is a good investment and that it behaves like gold and will keep up the value of the portfolio especially in trouble times. I would thus give the same advice as with gold as land offers no return.

Ok guys that is all. As you can see a well diversified portfolio is a good inflation strategy as over the long term its return will be greater that inflation.

Happy investing.

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