Inflation can be a challenge for investors—especially those with little exposure to stocks and a lot of money in cash or bonds. If you believe future inflation will be an important investment consideration, taking steps to mitigate its impact may make sense.
For most investors, it can be a good idea to diversify across several different types of inflation-resistant assets and asset classes.
That could include some equity investments like commodity producers and REITs as well as some fixed income investments like Treasury Inflation-Protected Securities (TIPS).
It may also help to reduce exposure to investments that are more sensitive to inflation, such as certain Treasury bonds.
Inflation has cooled from the sizzling highs that singed the economy in 2022. Fidelity’s Asset Allocation Research Team (AART) believes the moderating trend will continue in 2023 but it may be difficult to return to the stable, low-inflation environment of the past 2 decades. To get an idea of what to expect, it can make sense to understand how exposed your investments are to ongoing inflation pressures.
Why inflation matters to your financial plan
Most people have seen inflation in action: Prices go up over time. That's why most things cost more now than they did when you were younger. Staying ahead of inflation may be an important reason to invest your savings in assets that offer potential growth to counteract its effects.
"Inflation is always important from a financial planning standpoint because you want to think about long-term financial objectives relative to your purchasing power," says Dirk Hofschire, senior vice president of asset allocation research at Fidelity. "The higher inflation may be, the higher your return target will need to be to maintain the purchasing power of your assets."
For instance, if the average annual inflation rate is expected to be 2%, to keep up with inflation an investor would need to build a portfolio with the potential to return at least 2% to maintain their purchasing power.
What you can do
To stay ahead of inflation, look at your investment mix as a whole and evaluate where you stand. There are no silver bullets—you may need a combination of investments to provide a potential return that can keep up with the effects of rising prices. And some investments may be better for the job than others.
"Stocks tend to keep up with inflation better over time than bonds because their earnings can adjust upward, due to stronger company pricing power," Hofschire says. "So if you're a young investor, 40 years from retirement, with a large allocation to stocks, it may not be necessary to add much additional inflation protection."
But retirees with a very conservative investment mix may be exposed to higher inflation risk. By adding inflation-resistant investments to your portfolio and diversifying across asset classes, you may be able to reduce this risk. It’s not all bad news though—people who are retired may already benefit from inflation-adjusted income through Social Security or annuities with cost-of-living adjustments. With interest rates rising, purchasing guaranteed income in the form of an annuity with cost-of-living adjustments may be more affordable now than it was just a couple of years ago. For those who haven’t yet claimed their benefits, waiting until full retirement age or even age 70 to claim Social Security can also be a way to boost inflation-adjusted income.
"And if inflation is more of a US issue than one for other countries, the dollar may weaken, so holding non-US currencies and assets may help diversify," Hofschire adds.
Since inflation erodes the purchasing power of money, if inflation was worse in the US compared to other countries, a dollar wouldn’t go as far as other, less affected, currencies. One way to get indirect exposure to non-US currencies is by investing in non-US companies.
Though inflation remains a factor throughout the world, some recent trends have shifted including the slowing of supply-chain disruptions and a weakening of the dollar’s strength relative to other currencies in the last quarter of 2022.
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Article initially appeared on fidelity.com
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