The rising price of goods and services is always front of mind when it comes to managing your finances – and attempting to beat inflation by investing should always be an option you consider.
Inflation was previously something a little arcane, a throwback to the way the economy used to be in the 1970s and 1980s.
Then, after the pandemic, it came roaring back onto the economic agenda and is now one of the biggest talking points in the country. When we talk about the cost of living, we’re talking about inflation.
The share market no different, because rises in inflation have had a huge impact on how people invest.
For example, if you earn 4% interest from your bank and the inflation rate is 7%, the real rate of return on your money is -3% – that’s before factoring in taxes you might need to pay on the interest earned. Inflation turns a theoretical gain into a real world loss.
It’s why you could potentially be going backwards by leaving the majority of your savings in cash and term deposits, as the price of goods and services are rising faster than the prevailing interest rates.
With rising inflation, it’s a good time to be exploring other options to make sure you stay ahead.
In this article we focus on:
- What is inflation?
- What does inflation mean for investors?
- How does inflation affect businesses and consumers?
- How to beat inflation by investing
What is inflation?
Inflation refers to the rise in the prices of goods and services.
Essentially, it’s how quickly the value of our money is diminishing over time in real terms, as higher inflation means the same amount of money buys fewer goods and services. Inflation is commonly measured by consumer price inflation (CPI), which measures the change in price of a typical basket of consumer goods and services such as housing, food, transport and health.
The Reserve Bank of Australia (RBA) has an inflation goal of between 2% and 3% on average over time.
It controls this by adjusting the cash rate, which is used by banks to set interest rates on loans and, indirectly, controls the amount of money in circulation.
Theoretically, if interest rates go down, banks lend more, which increases the net amount of cash, which makes that cash less valuable, which is inflation. Of course, when interest rates rise, the opposite cycle should take place.
Between 2011 and 2020, interest rates fell while inflation has been low. This has changed since 2020 because central bank and government stimulus has driven inflation to a multi-decade high of 7.8% in late 2022
Australia has had a relatively benign rise, with inflation running even higher in other parts of the world, such as the UK, where annual inflation reached a 40-year high of 10.5% in 2022.
So how do you beat inflation by investing? What asset classes work best?
What does inflation mean for investors?
Beat inflation by investing in shares
Investing in shares over a long period has been proven to be one of the best ways to beat inflation.
That’s because one of the central characteristics that helps companies and their investors endure or even profit from inflation is pricing power.
Pricing power allows companies to avoid inflation cutting into profitability by passing on rising costs to consumers.
It is best exerted by companies with a brand name or dominant market position (e.g. Apple), where there are few other options. It might be best seen here in Australia with Coles and Woolworths, or with the big banks.
Warren Buffett has been quoted as saying that shares are the best possible inflation hedge because companies should be able to produce something that is able to retain its profitability in inflationary times by raising prices.
Shares have historically outperformed cash because of the ability of businesses to pass price increases along to their consumers, resulting in higher income and returns for both the company and its investors.
Over the 10 years prior to December 2021, Australian shares returned 9% p.a. nd global shares converted into Australian dollars returned 14% p.a., both well ahead of average inflation at 2.6% p.a.
In contrast, keeping money in cash provided returns close to or less than inflation – in practice, losses.
Source: Data as of 31 December 2022 showing 10 year returns. S&P/ASX All Ordinaries Index, MSCI World ex Australia Index, LBMA Gold Price AUD, Bloomberg AusBond Composite 0+ Year Index, Bloomberg AusBond Bank Bill Index, Australia CPI.
Inflation impact on bonds
Inflation typically has a negative impact on bonds, as rising prices can eat into the future interest you receive from bonds (known as coupon payments).
When inflation rises, it is normally followed by a period of rising interest rates, which causes bond prices to fall (given their inverse relationship).
Some bonds can help protect against inflation such inflation linked bonds (which Stockspot offers as a theme), as the principal and interest payment is linked to changes in CPI.
Stockspot recognised the risk inflation posted on government bonds and a portfolio risk mitigator and reduced our allocation to bonds in favour of gold in February 2021.
Inflation impact on housing prices
Can you beat inflation by investing in property? Well, the impact of inflationary pressures on property depends on the type of inflation.
When growth is slow and inflation is high (known as stagflation), as was seen during the 1970s, property generally does not perform as well.
Inflation generally leads to higher interest rates which in turn reduces the appeal of assets like property.
This is because future cashflows including rents are worth less in today’s terms because of the erosion caused by inflation.
Higher interest rates also lead to higher mortgage repayments and a reduced capacity to leverage and service the debt attached to an asset like property.
If inflation remains high and interest rates remain low (as has been the case for most of the last decade), then homeowners with a mortgage can benefit from inflation devaluing the interest payments while the value of the home keeps up with inflation, thus lowering the overall loan to value of mortgage debt.
Inflation impact on gold
The idea of being able to beat inflation by investing in gold is one that makes sense.
Gold has been a proven asset class over time that preserves its value and acts as a hedge against inflation.
When inflation rises, the value of paper money declines (also known as currency debasement) and commodities such as gold help protect against this because they have limited supply.
Gold has historically performed best when real interest rates are negative, which occurs when inflation is higher than prevailing interest rates.
Commodities refer to a basket of oil, gas, copper, aluminum, nickel, gold and silver.How does inflation affect consumers and businesses?
When prices rise, businesses experience an increase in input costs (referred to as cost-push inflation) as the price of raw materials goes up or as workers seek wage increases to combat inflation.
These cost pressures mean that businesses either have to pass on these costs to the end consumer (if they have strong pricing powers) or have to absorb the rise as part of their own costs, which could affect business profitability and impact their spending and investment decisions.
If the price of goods and services are rising faster than wages, then the consumer’s purchasing power (i.e. the value of their dollars) is reduced.
If the RBA then raises the cash rate, it can help savers – who experience a better rate – but negatively impacts mortgage holders, especially those on variable rates, who see their repayments go up.
How to beat inflation by investing
The best tip on how to beat inflation by investing is to harness the power of diversification.
By investing some of your savings in a portfolio of shares, bonds and gold, you’re able to gain exposure to investments that have historically stayed ahead of inflation.
Meanwhile, diversification across sectors and geographies can help reduce the risk of being overly exposed to individual companies.
Stockspot has made the diversification part easy by offering portfolios that provide exposure to thousands of stocks and bonds around the world in a cost-effective manner.
This helps to reduce the amount of risk our clients need to take to achieve returns that aim to beat inflation over the long run.
