Inflation is Dangerous to Investors

Inflation is something every investor should fear. If inflation gets out of hand, every plan you have made may go right down the toilet.

I don’t want to sound like an alarmist, but anytime you read or hear about heighten concerns over inflation you should probably pay attention.

Inflation is when the price of goods and services rises at a rapid rate and destroys purchasing power. Stated another way, it is when there is too much money chasing too few goods and services causing prices to increase.

Stocks are Protection

In theory, stocks should be able to absorb the effects of inflation as revenue and earnings increase at the same pace. Of course, for this to happen prices have to rise. Since many companies face global competitors that may not have the same inflationary pressures, raising prices fast enough to keep up with inflation may not be practical.

Another problem is the cure for inflation is raising interest rates, which cools the economy. A cooling economy may not be the best news for all companies.

If higher interest rates cause consumers to reduce spending, that’s a big problem for any number of sectors of our economy, which depend heavily on those dollars.

Back to the theory that stocks are good protection against inflation (and it has generally been correct for a broadly diversified portfolio). If you are 100 per cent invested in stocks, you may have some protection from inflation. However, any diversified portfolio will have cash and/or fixed income securities as part of the mix and that’s a completely different story.

Like a Hot Knife

Inflation destroys cash and fixed income investments like a hot knife through butter. Your 7 percent bond just went into negative returns with 8 percent inflation.

For investors in or preparing for retirement, inflation poses a serious threat. At a time when they should be thinking about reducing their exposure in equities and increasing their percentage of fixed income securities, that’s just the wrong thing to do.

Even in a low inflation environment, many retirees keep a portion of their portfolio in stocks to counteract the erosion of purchasing power.

In a high inflation period, staying in stocks that carry a greater risk puts retirees and near retirees in an uncomfortable position.

What Should Investors Do?

Don’t panic and make changes to your portfolio unless there is a real problem and not the “potential” of a problem. In the meantime, keep an eye on your portfolio, especially if you are at or near retirement and have a heavy percentage of fixed income securities. If inflation rears its ugly head, you may need to move some of your money back into equities to protect your capital.