The stock market has been on a roller coaster ride in recent years. The Federal Reserve’s policy of low interest rates and quantitative easing has created an environment that is ripe for inflation. What happens to your investments when there is high inflation?
In this article, we will discuss how the policies of the Federal Reserve can impact stock prices due to inflation!
What Is The Value Of A Dollar?
The value of a dollar is constantly changing and fluctuating – this can be seen by looking at the Consumer Price Index (CPI). The CPI measures how much prices for consumer goods are going up or down in comparison to previous years, and what we’re seeing now is that they’re increasing! And that means there is inflation.
In times of rising inflation, the Federal Reserve will raise interest rates in order to make it more expensive for businesses and individuals to borrow money, as borrowing money becomes riskier with higher inflation. The result of this is that people will save their money instead of spending it because they’re worried about the value decreasing even further!
Investors need to be aware of this and understand how it can affect their investments – with inflation, the purchasing power decreases over time which affects stock prices! One of the most famous examples of this was during World War II when inflation rates were 24% and consumer goods were scarce. Worse, the federal government was issuing a lot of new currency to pay for war expenses. As a result, there were more paper dollars in circulation than there were goods and products on the market!
The stock market showed a dramatic increase in value during this time, but when the war ended and people stopped worrying about getting goods for high prices, inflation rates dropped back down. The effect was that investors saw their investments shrink in value over the course of just a few years due to these unexpected changes in consumer behavior from rising inflation rates.
How Does Inflation Impact The Stock Market?
In the U.S., inflation rates have fluctuated wildly in the past century, with a baseline of about three percent yearly growth (though this can vary). These fluctuations are caused by natural and economic events that affect inflation rates on an international scale. For example, the COVID-19 pandemic.
The effects of these changes in inflation rates can be seen on a macroeconomic level. However, the impact on investments is often far more pronounced for individuals and those looking to invest their money. In fact, it’s not uncommon that an investment may lose considerable value due to inflation during any given year–especially if there has been a recent increase.
Inflation isn’t always a bad thing for the stock market, however. In certain instances, stocks have been able to offset the effects of inflation by increasing in value. For example, if a company is experiencing steady growth and has an excellent product or service which appeals to consumers–then this can lead them to invest more money into that company’s stock for future gains. This is what is known as a value stock, or a stock that tend to have healthy financials, and a history of steady returns.
Value Stocks vs. Growth Stocks During Inflation
One way that investors can protect their portfolios from inflation is by investing in stocks with higher earnings. These types of stocks are referred to as “value” and are often hedged against inflation because they generate more consistent returns (i.e., due to a history of high dividends or past market performance). However, there’s nothing wrong with investing in low-earning growth companies during periods of economic expansion–just be aware that this could lead to lower than usual returns if the economy turns increasingly sour.
Value stocks are very popular among some veteran investors such as Warren Buffett because they are less volatile than growth stocks, which tend to be more cyclical and affected by the economy. That said, growth investors will undoubtedly do better during periods of high inflation as they invest in companies that have a higher risk profile; conversely, value investors may feel the pinch if interest rates rise substantially due to concerns over underlying economic conditions. Investors who want exposure to both types should consider seeking out mutual funds with balanced holdings rather than buying individual stocks on one side of the spectrum.
The best way for an investor to gauge how their investments may be impacted by inflation is to figure out what type of securities they hold–growth or value stock? Investors who want exposure to both types could also consider seeking out mutual funds with balanced holdings rather than buying individual stocks on one side of the spectrum.
Other Inflation Investments
If inflation looks like it will persist for a significant duration, an investor could also consider purchasing inflation-protected securities such as Treasury Inflation-Protected Securities (TIPS).
In the case of TIPS, they would generate a modest higher yield in terms of interest income and, perhaps more importantly, provide protection against long periods of deflation or high levels of inflation. The added benefit for investors is that their nominal value adjusts to reflect changes in the level of inflation.
Likewise, inflation can also push investors to levy a hedge against their equities investments. For example, if you’re looking to invest in the stock market but are worried about inflation eating away at your returns–you might want to consider investing some of your money into commodities instead. Commodities tend not to fluctuate as much with inflation and generally have lower risk levels. One of the most famous commodities that investors gravitate towards in times of inflation is gold. Widely considered a “safe haven” asset, gold prices tend to rise during times of inflation.
So What Should You Do?
There are a number of ways to approach investments during times of inflation. You can certainly take a defensive position by investing in commodities instead of stocks or bonds–just keep in mind that, while this approach may be helpful during inflationary periods, it will likely lead to lower returns than you would have seen if you remained invested.
The other option is to reserve your investments for the short-term and hold onto them until they’ve begun appreciating again. The trouble with this method though is that, when inflation rates are high enough (and long-lasting), your money might not even be able to buy what an investment originally cost anymore.