When it comes to inflation, the question on many investors' minds is: "How will it affect my investments?" This is an especially important issue for people living on a fixed income, such as retirees.

The impact of inflation on your portfolio depends on the type of securities you hold. If you invest only in stocks, worrying about inflation shouldn't keep you up at night. Over the long run, a company's revenue and earnings should increase at the same pace as inflation. The exception to this is stagflation. The combination of a bad economy with an increase in costs is bad for stocks. Also, a company is in the same situation as a normal consumer - the more cash it carries, the more its purchasing power decreases with increases in inflation.

The main problem with stocks and inflation is that a company's returns tend to be overstated. In times of high inflation, a company may look like it's prospering, when really inflation is the reason behind the growth. When analyzing financial statements, it's also important to remember that inflation can wreak havoc on earnings depending on what technique the company is using to value inventory.

Fixed-income investors are the hardest hit by inflation. Suppose that a year ago you invested $1,000 in a Treasury bill with a 10% yield. Now that you are about to collect the $1,100 owed to you, is your $100 (10%) return real? Of course not! Assuming inflation was positive for the year, your purchasing power has fallen and, therefore, so has your real return. We have to take into account the chunk inflation has taken out of your return. If inflation was 4%, then your return is really 6%.

This example highlights the difference between nominal interest rates and real interest rates. The nominal interest rate is the growth rate of your money, while the real interest rate is the growth of your purchasing power. In other words, the real rate of interest is the nominal rate reduced by the rate of inflation. In our example, the nominal rate is 10% and the real rate is 6% (10% - 4% = 6%).

As an investor, you must look at your real rate of return. Unfortunately, investors often look only at the nominal return and forget about their purchasing power altogether.



Inflation
-Indexed Bonds
There are securities that offer investors the guarantee that returns will not be eaten up by inflation. Treasury inflation-protected securities (TIPS), are a special type of Treasury note or bond. TIPS are like any other Treasury, except that the principal and coupon payments are tied to the CPI and increase to compensate for any inflation.

This may sound like a good thing, but the running joke on Wall Street is that it's easier to sell an air conditioner in the dead of winter than it is to convince investors they need protection from inflation. Inflation has been so low in recent years that it hasn't been much of an issue. Because these securities are so safe, they offer an extremely low rate of return. For most investors, inflation-indexed securities simply don't make sense.


Next: Inflation: Conclusion »



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