What is Inflation

Inflation in investment refers to the rate at which investments lose real value and prices rise over time. It shows how much return is needed to maintain a certain standard of living, reflecting the decreasing purchasing power of money.
EXPLORE FUNDS
What is Inflation
EXPLORE FUNDS
3 min
19-September-2024
Inflation can be described as the gradual decrease in the purchasing power of a currency, which means that over time, your money buys less than it used to. Inflation can be measured by tracking the average price increase of a basket of goods and services in an economy. If the prices go up, each unit of currency buys fewer goods and services, leading to inflation.

Inflation impacts everyone, from consumers to investors to policymakers. It refers to the general rise in prices for goods and services, which leads to a decline in the purchasing power of money. Essentially, when inflation rises, you need more money to buy the same amount of goods and services as before. Understanding inflation helps you make better financial decisions, whether you are saving for the future, investing, or just managing daily expenses. By grasping its causes and effects, you can navigate the financial landscape more effectively.

This article explores the concept of inflation, its impact on investments, and whether inflation can actually benefit your portfolio. We'll dive into how rising inflation rates affect different asset classes and what investors can do to manage inflation risks. Additionally, we'll examine how inflation interacts with various types of investments and provide insights on navigating inflationary periods to optimize your financial strategy.

What is the meaning of inflation?

Inflation happens when the amount of money in the economy increases. This can occur due to various reasons, such as when central banks print more money or when new money is created through the banking system, thus legally devaluing the tender currency. As more money circulates, its value decreases, leading to higher prices for goods and services. This decrease in money's purchasing power is what we refer to as inflation. It is important to understand what is inflation and how it works because it affects your spending power and the overall economy.

Also read: What is Inflation Risk

How does inflation affect investment?

Inflation affects investments by reducing their real value over time. If inflation is high, the money you earn from investments will have less purchasing power. For instance, if you earn a 4% return on an investment but inflation is 5%, your real return is negative because your earnings do not keep up with rising prices.

Inflation occurs when the money supply grows faster than the economy's production. This results in more money chasing the same amount of goods, driving prices up. As an investor, you need to seek returns that at least match inflation to preserve your wealth. For example, if a stock returns 6% but inflation is 3%, the real return is 3%. Understanding inflation helps you choose the right assets to protect and grow your investments.

Also read: How to Invest During Inflation

Can inflation be suitable for your investment portfolio?

While you cannot control inflation, you can adopt strategies to protect your investment portfolio from its effects:

Optimum diversification

Diversify your investments across different types of funds, such as equity, debt, and hybrid funds. This helps balance your portfolio and reduces the risk of any one investment performing poorly during high inflation.

Regularly review and make adjustments

Monitor your portfolio and make adjustments as needed. If inflation leads to high interest rates, consider reducing debt fund investments. Conversely, when inflation is low, you might increase your exposure to debt funds and equities. Building a resilient portfolio is like constructing a sturdy house – it requires a solid foundation and a balanced mix of investments to withstand economic changes.

What causes inflation?

Inflation arises from three main sources: demand-pull inflation, cost-push inflation, and built-in inflation.

Demand-pull effect

Demand-pull inflation occurs when increased money supply and credit boost overall demand for goods and services beyond the economy's production capacity, causing prices to rise. When people have more money and are optimistic, they spend more, driving up demand and prices.

Cost-push effect

Cost-push inflation happens when production costs rise, leading to higher prices for finished goods and services. This can occur when the money supply increases and flows into commodity markets, causing prices to spike. For example, if oil prices rise due to increased money supply, the cost of energy goes up, leading to higher prices for various goods and services.

Built-in inflation

Built-in inflation is driven by expectations that current inflation rates will continue. When people expect prices to keep rising, they demand higher wages to keep up with the cost of living. Higher wages then lead to increased production costs, perpetuating the cycle of rising prices.

Also read: What is the Consumer Price Index

Effects of rising inflation rate

Rising inflation impacts more than just purchasing power. It affects investments, savings, and the broader economy. High inflation erodes the value of money, making it essential to adjust financial strategies to maintain real returns and protect wealth.

Inflation and asset classes

Inflation affects liquid and illiquid assets differently. Liquid assets, like cash, appreciate slowly and are more vulnerable to inflation. High inflation leads people and businesses to hold fewer liquid assets. Illiquid assets, like property or stocks, may appreciate or generate interest, providing some defence against inflation. Investing in mutual funds, stocks, and bonds can help protect savings. Inflation-protected securities, like Treasury Inflation-Protected Securities (TIPS), offer returns that adjust with inflation, safeguarding purchasing power.

Impact of inflation on mutual funds

Inflation can reduce the real returns of mutual funds, affecting their performance. As prices rise, the purchasing power of returns decreases. It’s crucial to adopt strategies to mitigate inflation’s impact on investments.

How to combat the impact of inflation on mutual funds?

To combat the impact of inflation on mutual fund schemes, diversify your portfolio across various asset classes, including equities, bonds, and commodities, to balance risk and returns. Regularly review and adjust your investments based on market conditions and inflation trends. Additionally, focus on high-quality, dividend-paying stocks, as they tend to perform well during inflationary periods. Maintaining a well-diversified and actively managed portfolio can help cushion the effects of inflation and protect your investment returns over time.

Optimum diversification

Diversify your portfolio across various funds to balance performance during inflationary periods. Include equity, debt, and hybrid funds to spread risk and enhance returns.

Regularly review and make adjustments

Keep an eye on your portfolio and make necessary adjustments. If interest rates rise due to inflation, reduce debt fund investments. When inflation is low, increase debt fund exposure and equity allocation to optimise returns.

To protect your portfolio against inflation

Here are some investment options that provide inflation-adjusted returns:

  • Inflation-indexed securities: These bonds have their principal indexed to inflation, offering returns higher than the inflation rate, protecting your investments from inflation.
  • Floating interest rate products: These products adjust coupon payments with changing interest rates, offering protection against inflation.
  • Commodity prices: Investing in commodities can hedge against inflation, as their prices rise with inflation.
  • Equity income funds: These funds invest in dividend-paying companies, providing income and protection against inflation.
Also read: Cost Inflation Index (CII) for FY 2024-25

Key takeaways

  • Inflation measures how quickly investments lose real value and how prices increase over time.
  • It indicates the necessary returns for investments to maintain a specific standard of living.
  • Inflation occurs when the money supply grows faster than the economy's productive output.
  • A price rise in one product is not inflation but a relative price change due to supply or demand shifts.

Final Words

Understanding inflation is important for making informed financial decisions. It measures the rate at which investments lose value and prices rise, affecting purchasing power and living standards. Inflation results from an increase in the money supply relative to productive output. While a price increase in one product is not inflation, a general rise in prices across the economy is.

While cash and fixed-rate bonds tend to underperform during inflationary periods, diversifying your portfolio and opting for investments with inflation-protected returns can help mitigate these effects. Platforms like Bajaj Finserv make this process more accessible and efficient. With over 1,000 mutual funds available on the Bajaj Finserv Platform, you have a diverse range of options to build a robust investment portfolio and compare mutual funds. With extensive research from in-house specialists and a wide array of mutual fund options, including tools like a mutual fund calculator, Bajaj Finserv ensures a seamless and informed investment experience. By leveraging such resources, you can build an investment portfolio capable of combating the impacts of inflation.

Frequently asked questions

What is inflation and its effect on investment?
Inflation affects the economy by reflecting the speed at which investments lose their real value and the rate at which prices rise over time. Inflation also determines how much of a return investments would need to maintain a particular standard of living.

What is the effect of inflation and interest rates on investments?
Fixed-income investments typically yield lower interest rates compared to the higher rate of inflation. Since bond prices move inversely with interest rates, rising inflation leads to higher interest rates, which in turn decreases the value of existing bonds.

What is the inflation risk of investments?
Inflationary risk refers to the threat that rising prices will decrease the real value of investment returns by reducing purchasing power. Bonds are especially susceptible to this risk because their fixed interest payments become less valuable as inflation rises.

How does inflation and deflation affect investments?
Moderate inflation around 2% is beneficial for investors, while deflation harms nominal returns but benefits real returns. High inflation can make nominal returns seem acceptable but actually results in negative real returns.

What are the five effects of inflation?
The five effects of inflation include reduced purchasing power, increased interest rates, higher prices for goods and services, slower economic growth, and the potential for anti-inflationary measures to trigger a recession.

What causes inflation to rise?
Inflation can increase due to three main factors: demand-pull, cost-push, and inflation expectations. Demand-pull inflation happens when demand for goods and services exceeds supply. Cost-push inflation occurs when the costs of production rise, leading to higher prices for consumers. Inflation expectations can also drive prices up if people expect future inflation and act accordingly, such as by demanding higher wages.

How does inflation affect mutual funds?
Inflation diminishes the real value of mutual fund returns, meaning that even if the nominal returns are positive, the actual purchasing power of those returns can decrease. This impact requires investors to adopt strategies that can mitigate inflation's effects, such as investing in funds that historically perform well during inflationary periods or including inflation-protected securities in their portfolio.

What are the worst investments during inflation?
During periods of high inflation, certain investments tend to perform poorly. Cash loses value rapidly as purchasing power decreases. Fixed-rate bonds are also poor performers because their returns do not adjust with rising inflation, leading to diminished real returns. Additionally, companies with weak pricing power struggle to pass increased costs onto consumers, resulting in lower profit margins and poor investment returns.

How to factor in inflation in investment?
To account for inflation in your investment strategy, diversify your portfolio across various asset classes, including stocks, bonds, and commodities. Consider including inflation-protected securities like Treasury Inflation-Protected Securities (TIPS). Regularly review your portfolio and adjust your investments based on current inflation trends and economic forecasts to ensure your investments keep pace with inflation.

Is inflation good or bad for investors?
Moderate inflation is generally beneficial for investors as it signals a growing economy, potentially leading to higher returns. However, high inflation can erode real returns, making it difficult to preserve purchasing power. Investors need to seek returns that outpace inflation to maintain their wealth and standard of living.

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