As daunting as it may sound, your investment portfolio is as big of a commitment as your nuptials and in these trying times of market uncertainty, are you richer or poorer?
At a minimum, investors should seek investment opportunities that retain the purchasing power of their money and generate a return in excess of inflation, referred to as the real rate of return.
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Why is inflation important?
To comprehend how inflation can reduce investment returns, it’s important to understand the difference between nominal and real interest rates. The nominal interest rate is a return that is not adjusted for inflation. Therefore, this is the interest rate you would earn if inflation was at 0%. The real interest rate takes inflation into account and is a representation of whether your investment portfolio has gained or lost purchasing power. Therefore, to arrive at the real rate of return, you would deduct the rate of inflation from the nominal interest rate. For example, if inflation is 6% and the nominal interest rate is 10%, the real rate of return is 4%.
The impact of inflation on returns
From a theoretical perspective, inflation is the increase in the prices of goods and services. Generating investment returns more than inflation over time is important to ensure that your capital retains its purchasing power over time.
The role of different asset classes
Some asset classes have the ability to protect against inflation, whilst periods of high inflation may erode the real return on other asset classes.
From a theoretical standpoint, equity returns may hedge against inflation. This is primarily driven by the notion that a company’s profits increase at the same pace as inflation due to the ability to pass through inflation to customers. Therefore, the share price of a company is expected to at least increase in line with inflation. However, not all companies respond the same to inflation. During periods of high inflation, value stocks (undervalued companies) are expected to outperform growth stocks (companies with high growth potential). Inversely, growth stocks will most likely outperform value stocks during periods of low inflation.
Property as an asset class may hedge against inflation due to an expected increase in prices and rental income when there is a rise in inflation. In theory, property owners require higher returns to offset rising input and consumption costs. A property owner increases the rental charged according to inflation, thus increasing profits earned and dividends paid to investors. It can therefore be said that property is an asset class that is highly correlated to inflation in most cases.
Nominal (fixed-rate) bonds do not provide protection against unexpected inflation. An allocation to fixed-rate bonds provides investors with a stable income stream in the form of interest payments. However, due to the fixed nature of interest payments, the purchasing power of returns diminishes as inflation rises; most notably on longer-dated bonds.
Inflation-linked bonds, however, are a sub-asset class within fixed income that adjusts returns based on inflation, known as an inflation accrual. Another potential inflation hedge is floating-rate bonds as central banks tend to increase short-term interest rates during periods of rising inflation.
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Commodities such as gold have traditionally been considered a good option to offer inflation hedges, as the value of your investment portfolio is protected during times of rising inflation.
How to defend your portfolio against inflation
Inflation can erode the purchasing power of your investment portfolio over time. It is, therefore, important to diversify your portfolio to include real growth assets such as equities.
Although some asset classes may provide a hedge against inflation over time, there are other market variables that drive asset class returns that investors should be aware of. This includes economic growth, interest rates and isolated asset class dynamics.
Understanding and keeping track of asset classes through different market cycles is often complex. By partnering with a discretionary fund manager (DFM) financial advisors can make sure that there is alignment between their advice process and the investment portfolios that their clients invest in.
Thami Khoza is a portfolio manager at Equilibrium.