Inflation: Shrinking Your Wallet and Your Wealth
November 16, 2021
3-5 minutes reading time
If you live in Canada or the US you probably noticed, we’ve been experiencing a surge in inflation over the last few months. The latest US numbers just came out last week - consumer prices rose a whopping 6.2% from October last year, the highest reading in over 30 years.
Economists attribute it to several reasons: monetary and fiscal expansion, pent-up consumer demand, tight oil supply, and general supply chain constraints. All of this simply means we’re paying higher prices everywhere. But inflation doesn’t just impact your spending, it also affects your wealth in ways you probably didn’t know.
Inflation is actually a primary driver behind the prices of most financial assets. In fact, inflation is such an important economic factor that the primary responsibility of most central banks around the world (e.g., Bank of Canada, US Federal Reserve) is to simply manage it. Here in Canada and in the US, that inflation target is around 2%, and is represented by the Consumer Price Index (CPI).
So, how does inflation impact your wealth?
A lot may be at stake. Nearly 80% of Canadians have investments and the average Canadian household has about 60% of their net worth in financial assets (1). Most Canadians have investments in either mutual funds or ETFs, which predominantly invest in stocks and bonds, or, they have investments in cash products: all of which can be quite negatively impacted by inflation.
Interest rates are the biggest source of risk for bonds. Rising inflation drives interest rates higher, and when interest rates rise, bond prices fall. The reason for this is bonds usually pay a fixed cash flow so when inflation rises (and interest rates rise), the present value of those future cash flows are worth less.
For stocks, the impact can be mixed depending on what types of stocks you own. Higher inflation means higher cost of raw materials for companies that produce goods. However, some companies are often able to pass on those higher costs to their customers, thereby mitigating the effect of inflation.
On the flip side, there are other types of stocks that can be negatively affected by inflation - the largest group of which are what’s known as “growth” stocks. For these types of companies, the expectation is that the bulk of their cash flows will be generated in later years, instead of immediate years. And because money loses value over time (due to inflation), the stock prices of these companies are especially sensitive to changes in inflation and interest rates.
As you probably figured out, inflationary pressures and higher interest rates have a negative impact on growth stocks. If you’ve been lucky enough to participate in the growth rally over the last couple years by owning technology stocks (a big component of growth stocks), you may want to start taking some profits and diversify elsewhere.
So… diversify where?
Thankfully, there are many investments that can actually outperform in an inflationary environment. If some of the investments below are new to you - don’t be alarmed - it’s because most mutual funds, robo-advisors, and traditional wealth managers don’t offer them.
- Alternative investments: Whether it’s private market investments, event-driven strategies, or market neutral strategies, alternative investments offer a high degree of diversification to your portfolio because they often have little to no correlation with traditional stocks and bonds. In short, they can improve your portfolio returns while reducing risk.
- Digital assets: Despite the headlines and controversies around cryptocurrency and blockchain, many large corporations and institutions have already invested billions of dollars toward this space. Amongst its many advantages, blockchain technology protects digital assets from external manipulation by governments and central banks (which was one of the causes of inflation).
- Real assets: Real assets are investments in physical tangible assets such as commodities, infrastructure, and real estate. They provide an excellent hedge against inflation. If you’re not convinced, just look at the recent rise in housing and gas prices.
- Real return bonds: Real return bonds, also known as inflation-protected bonds, are issued by governments and pay out coupons that are adjusted for inflation. If inflation unexpectedly increases, your coupon payments automatically increase as well.
The majority of the surge in consumer prices occurred over the last 8 months. During this period, both bonds and technology stocks underperformed, while the other types of investments listed above saw positive returns.
If you’re unfamiliar with the investments mentioned above, it can feel overwhelming. Fortunately, all of these products are available to everyone (and, not just wealthy investors) through OneVest’s managed account platform.
If your current portfolio is entirely low-cost passive ETFs, you may be exposing yourself to undesired risks (such as inflation) that will more than wash out those fee savings. If you’re invested in a balanced mutual fund, you’re likely exposed to the same risks as above, and you’re stuck paying those exorbitant fees.
Ready to take the next step in your wealth journey? OneVest takes a modern approach to portfolio construction and active management, bringing you a private wealth management experience like never before. Many wealth managers rely solely on low-cost passive ETFs because frankly it’s less work for them. Navigating financial markets requires skill, time, and a lot of resources. We spend all our time doing investment research so that you don’t have to, and build portfolios that help you reach your goals faster.
Sign up for the OneVest beta today and start accelerating your financial goals!