Consider the effects of inflation before making investment decisions.
Inflation can affect many aspects of our lives, from the cost of food to how much we spend on a new car or a new house. Though you may not notice over the short-term, inflation can have a substantial long-term negative effect on your purchasing power – and your investment portfolio. Consequently, investors need to be aware of the risks and know what steps they can take to protect their portfolios from inflationary pressures.
Simply put, inflation is the rate at which the price for goods and services – and therefore the cost of living – rises. There are a number of factors that can cause inflation including supply and demand issues, consumer confidence and rising wages.
Although inflation has been relatively low over the past several years, it can rise quite dramatically, as the chart below illustrates, and that can quickly erode your buying power. For example, in 1981, inflation rose more than 12% from the previous year. To help people maintain their standard of living, wage increases and government social benefits are often linked to the rate of inflation.
The effects of inflation
When making investment decisions, it’s important to consider the adverse effects of inflation. This is especially important for Registered Retirement Savings Plans (RRSPs), when contributions are made to provide retirement income in the future. For example, if annual inflation is at 2%, in just 10 years (compounded annually), investors will have to withdraw almost $122 from their RRSP to purchase the same products that cost $100 today.
Protect your portfolio
Fortunately, there are a number of strategies you can employ, and specific securities you can purchase, to help protect your investments from the impacts of inflation and rising interest rates.
Inflation-linked bonds guarantee that an investor’s returns are not reduced by inflation because the bond’s principal amount and subsequent interest payouts are adjusted to reflect the changes in inflation, so they are worth considering when inflation is high or expected to rise.
Floating-rate notes are attractive when interest rates are expected to rise because the interest rate of the bond is linked to market rates. When interest rates rise, the bond’s interest payment (coupon) increases, protecting the investor. In contrast, bonds with fixed coupons lose value when interest rates rise.
Equities – Another way to combat the effects of inflation is to invest where your money will grow faster than the inflation rate. History has proven that the returns on stocks exceed the rate of inflation over time. Over the past 20 years, the average inflation rate in Canada has been 2% while the average annual performance of the S&P/TSX Composite Index was 11.0%.1
Commodities – Commodity prices and inflation are closely linked, so investors who have a higher risk tolerance can capitalize on rising commodity prices during periods of rising inflation.
To find out more, talk to your financial advisor or visit AGF.com.
1 Sources: Statistics Canada, Bloomberg, December 2014.
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