One of the strange things about economic life is that the price for things keeps rising. In most cases, many household consumers comprehend that inflation increases the price of household goods or decreases the value of the money in their pockets.
As a matter of fact, Inflation affects all areas of the economy. For instance, if you are an investor, inflation can take a bite out of your investment returns.
On the flip side, if you are a smart investor, you can benefit from inflation by ensuring that your money is in investments that are likely to benefit from it.
To understand how inflation can influence part of your investment returns; it’s important to differentiate between nominal and real interest rates.
Inflation is a measure of how fast the prices of goods and services are rising.
In a given country, as the economy grows, businesses and consumers spend more money on goods and services.
In the growth stage of an economic cycle, demand in most cases exceeds the supply of goods, and producers can raise their prices. For that reason, the rate of inflation increases.
What causes inflation to happen? According to economists, basically, they are three reasons:
Cost push inflation – This is where the cost of business operation rises, and it is passed to the consumers by raising prices of goods and services. It’s a scary move by the business people but they have to do it or else, they would go out of business.
Demand inflation – The most common cause of demand inflation is interestingly when people are getting richer and have more money to spend. This will happen when many people in a given economy/ market demand for goods whose supply can’t be kept up. As a result, prices of goods go up.
Government printing money – The government often wants to stimulate the economy, so they print more money. Literally, this can be done either by increasing the number of notes in circulation, by increasing government debts or by letting banks make bigger loans on the same security. All these causes the amount of money in circulation to increase. After a while, it means the worth of every note starts to fall because notes are chasing the same number of goods to buy.
How can Inflation influence your saving?
With the effect of inflation on savings; after some time, the value of the money saved could be much lesser than when it was earned and saved.
Inflation has a corrosive impact on your savings.
The price of a tomato, a house, or a packet of flour tends to rise over time, sometimes quickly and at other times slowly. That fact is very relevant for your personal savings plan.
Every time the prices of goods and service rises, it affects your cost of living, leaving a dent in your savings. This is because, with the rise in inflation, the amount you save from your income every month may not rise at the same rate.
For that reason, Due to the effect of inflation, the rise in price puts extra pressure on your savings. After a few years, the amount you have saved will fetch you a lesser number of goods.
When you save your money in the bank, you may earn the same interest, this can balance out some of the effects of inflation.
For instance, when inflation is high, in most cases, banks will pay higher interest rates. However, your savings may not grow fast enough to completely balance off the effect of the inflation loss.
Let’s look at the following example, you have $ 2,000 in your savings account; Based on an inflation rate of 2% per year, in 20 years’ time, the estimated value of your money in today’s terms might be: $ 1,345.94.
How can Inflation influence your investments?
The impact of inflation on investments depends on the investment type. For example, inflation can have a negative effect on investments like fixed income securities which provide investors with a set annual return.
In most cases, individual and institutional investors invest in fixed income securities because they provide a stable income stream paid in the form of coupons or interest payments each year.
Inflation can considerably affect the expected real returns on these fixed income securities. Correspondingly, rising inflation erodes the value of the principal on fixed income securities. Just the same way it does to your savings in the bank.
Most investors aim to increase their long-term purchasing power, in spite of that, when the rate of interest remains the same on most fixed income securities up to maturity, the purchasing power of the interest payments declines as inflation rises.
To protect your investment as an investor, consider putting your money in equities. According to trends and historic data, over a long time, stocks have held up well against inflation. This is because companies can raise the prices for their products when their costs increase due to inflation.
As an investor, Inflation might be beyond your control, but that does not mean you cannot take actions to help preserve your investments and savings from its effects.
By planning for it and putting a strong investment strategy in place, one might be able to help minimize the impact of inflation on long-term financial plans on their investments and savings.
Because inflation erodes the value of investment returns over time, investors may shift their money to markets with lower inflation rates or keep some of their money in potentially higher growth investments like stocks or mutual funds.
The only way to deal with inflation successfully, is to be sure that money is invested in investments that are likely to benefit from inflation. Investors should avoid at all cost investments that tend to be especially hard hit.
Due to the negative effects it has on the economy, Governments track inflation obsessively and try to keep it low. This is beneficial to investors in the long run.