Diversification is a key strategy to lowering the volatility of your investment portfolio. We know that each stock has its own riskiness profile and a good balance between high return, growth, and security investments can help minimize the overall risk you develop while maintaining an adequate average return.
However, diversification can’t reduce all of the risks present in your portfolio. There are some types of risk, what we define as “systematic risk”, which is endemic to the market and not just to any singular security. This can range from a variety of factors such as political struggles, economic policies, and even simple changes in consumer behavior. For this article, we will explore one of the most popular systematic risks to affect an investor’s investments: inflation.
How Inflation Works
While inflation occurs in every market in the world, the exact concepts that go into the occurrence and policies that surround inflation can get complex very quickly. In a basic sense, inflation is a generalized trend of sustained increases in prices year-on-year, where the purchasing power of a dollar last year might not be as powerful as a dollar this year.
Many factors lead to inflation, and it can be found in almost every industry that buys and sells goods in the market. Often inflation can be explained away as a simple increase in production and labor costs causing a rise in the price that firms need to set for the goods, other times it can be as a result of other socio-economic factors such as sustained inflation demand over a specific good or category of goods or correlated events effects to a particular good, such as storms to specific agricultural products.
Often governments are tasked with setting a target inflation rate regarding their economies and can apply monetary policies such as interest rate increases and decreases to influence the rate of inflation.
Inflation and the Stock Market
While the inflation rate might be directly felt the most through consumer products and other direct purchases, investors should keep in mind the effects that the inflation rate of their economies have within their utilized currency.
As inflation affects the value of money as a whole, investors need to keep in mind the real return of their investments; that is the actual return that your investments generate after taxes and inflation are taken into account.
For example, if you’re an investor who regularly diversifies for a portfolio return of roughly 10%, but the current market inflation rate is at 4%, then your real return would only be 6% due to inflation valuation.
Inflation Around the World
Inflation rates change from economy to economy and remain highly variable to the different factors that are present at any given time.
Inflation in the Americas
The US is seeing historic rises in its inflation rates, hitting 7.5% in February 2022. Like all inflation events, this is a multi-variable issue, with high energy costs, strong consumer demand, labor shortages, and supply line disruptions. The country is currently waiting on word from its Federal Reserve (the Fed), the body that officially sets any monetary policy, in how it plans to curb these inflation prices. It is reported that the Fed is considering a sharp hike in their interest rates to slow down inflation, with some reporting that the Fed is considering as much as a 6-fold increase in interest rates.
Canadians can breathe a little easier compared to their neighbors, but they need to act fast to avoid falling into the same issues that America has. The current inflation rate was recorded to be at 4.8% this past January, owing to many of the same reasons that America is facing.
Investors should consider investing in high-performing stocks that beat the current inflation rate, such as AAPL which is considered to be trading at a low price compared to its valuation and past year return of 26.62%.
Inflation in Europe
Europe isn’t fairing any much better compared to their counterparts in the Americas, with their latest inflation rate record coming in at 4.6% in the fourth quarter of 2021. Uncertainty abounds in these markets, as supply chains and the Ukraine-Russia tensions threaten the economy that the European Union is working hard to keep to their target of 3% inflation.
Investors in the region should consider investing in the best returning ETFs in the market considering the wider scope that the European market encompasses. Diversifying your portfolio through these securities can help limit the impact a wide set of economies can have on your investments.
Inflation in Asia
Asia is the exception to many of these inflation woes. It seems that the Asian markets have continued their usual lower inflation record, with China showing just a 1.5% increase in the consumer price index and Japan showing no increase at all. It seems like just two developing countries, Sri Lanka and Pakistan, are experiencing bouts of inflation similar to the west.
In this region, investors can enjoy more flexibility with their investment choices, ranging from high-risk-high-reward stocks to less-risky securities like bonds and T-bills, which are usually difficult choices during high inflation rates due to their fixed interest rate schedules.
Final Thoughts on Inflation and Investor Planning
The inflation rate is a very complex issue but not too difficult to navigate yourself around with. As retail investors normally don’t influence to affect the inflation rate in any real means, smart investors should remain attentive to the current economy’s health to see if they need to adjust their portfolios accordingly.
Note: Please do not invest money or assets in the financial markets that you cannot afford to lose. This article should not be construed to be investment advice and is for information purposes only