Understanding The Impact of Inflation on Investment Returns.

Inflation stands as an enduring economic hazard that gradually erodes the purchasing power of our currency over time. Its impact poses a substantial challenge for us as investors, diminishing the genuine value of our returns from investments.

Therefore, understanding how inflation influences our investment returns is pivotal for making sound and decent financial choices and safeguarding our wealth despite escalating cost of living prices!

Typically, investment returns are quantified in nominal terms, without inflationary considerations. Nevertheless, it becomes important for us to factor in the real rate of return, which adjusts for inflation, to precisely evaluate the purchasing power gained or lost in an investment.

When inflation rates surpass the nominal returns on investments, as it has done in the past few years then we will encounter negative real returns. In other words despite the nominal increase in investment value, the actual purchasing power of returns diminishes.

This scenario proves particularly true with fixed-income investments such as with bonds, where returns remain fixed and may fail to keep pace with inflation. For instance, imagine you hold a bond with a fixed annual return of 3%. In a scenario where inflation runs at 5% per year, the real return on the investment would stand at -2% (3% nominal return minus 5% inflation rate), leading to a decline in your purchasing power over time!

On the other hand, Equity investments, such as stocks, generally serve as superior hedges against inflation when compared to fixed-income investments. This is because companies can adjust their prices and revenues to mirror inflation, thereby potentially upholding or increasing their real returns.

However, the extent to which stocks can outstrip inflation hinges on various factors including economic robustness, corporate earnings growth, and market dynamics.

Inflation can vary the impacts of Equities and Stocks across different asset classes. Real assets like real estate and commodities frequently demonstrate resilience during inflationary periods as their values tend to increase alongside prices. To shield your purchasing power, you may choose to allocate a segment of your portfolio to these assets.

As we have seen inflation can influence the interest rates determined by central banks, thereby impacting the cost of borrowing and investment decisions. In response to rising inflation, central banks might elevate interest rates to curb spending and stave off overheating of the economy.

Elevated interest rates can dampen investment activity and diminish the appeal of certain investments, especially those sensitive to changes in borrowing costs, such as real estate and consumer durables so also keep this in mind.

Our inflationary expectations will significantly determine our investment behavior. Should we anticipate higher future inflation, we might opt for Investments with higher returns to offset the erosion of purchasing power.

This will trigger an increase in asset prices and investment strategies as we strive to position ourselves suitably to capitalize.

Remember that the impact of inflation on our investment returns increases the significance of factoring in the real rate of return and implementing strategies to mitigate its effects. We can take certain measures to cushion ourselves such as diversification across asset classes, practicing risk management, and keeping updated with economic indicators and central bank policies to aid us in making decisions to overcome the challenges posed by inflation and preserving long-term wealth.

Once we can grasp the dynamics of inflation and its implications for investments, we can make well-informed decisions in pursuing our financial objectives despite a changing and ever-evolving economic landscape.

Retire 30% Wealthier, Click Here To Open Your Own Questrade Account

Find Out How Much Taxes You Will Pay For 2023 Click Here!

FREE RRSP Tax Calculator

Click Here To Book a One on One Consultation With Me

Setup Your Quick 3 Minute Financial Plan Here!

Join our Conversation on FaceBook