In this video, we will be learning about the effects of inflation on investment performance of assets such as bonds, stocks, commodities and real estate.

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In simple terms, Inflation is the rise in cost of buying goods and services. That is, a decrease in purchasing power of a unit currency such as the dollar.

The return on any investment can be classified as good or bad based on how much it increases the purchasing power of the amount invested.

For example, if the return on an investment is 10% whereas the inflation is 8%, the real return is only 2%. Which means that the actual increase in purchasing power of the invested amount is only 2%

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Inflation has a negative effect on fixed income investments such as government & corporate bonds, savings accounts and certificates of deposit. As these investments give out a fixed interest income at a regular time interval, the purchasing power of the interest income decreases due to inflation. The drop in purchasing power of the interest income results in a fall in prices for investments such as bonds.

In summary, the real return on fixed income investments decreases due to inflation.

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Sudden rise in Inflation increases the input costs for the companies and reduces the purchasing power of the consumers. Not all companies can increase the prices of their goods or services immediately in response to rising inflation, which negatively affects their finances. So inflation causes a drop in revenues and profits for the companies in the short term. It takes about a few quarters for the economy to reach equilibrium. However companies that have significantly strong pricing power in the market can increase the prices of their goods and services in response to inflation and such companies are less affected by the inflation. In general, it is observed that large size companies have a relatively positive correlation with rising inflation in comparison to mid size and small size companies. But inflation does reduce the real returns for investors. Inflation rate of 2 to 3% maximizes the real return for investors.

Another effect of rising inflation is that the central bank raises the short term interest rates to withdraw money supply from the economy, in order to contain inflation. The rising interest rate has a further negative effect on stock prices.

In summary, a very high and sudden rise in inflation has a negative effect on real returns of a stock portfolio.

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Commodities such as oil and gold have a positive correlation with inflation. Rising inflation results in rising prices of commodities because in the short term, the supply of commodities remains constant whereas the money chasing these commodities is higher. Hence commodities are a good protection against inflation.

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Real Estate has similar characteristics as commodities. The prices of real estate rise with rising inflation as there is more money chasing limited available real estate. Thus real estate is also a good protection against inflation….(read more)

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