As you know, inflation heated up in 2021, following years of pretty stable—and low—numbers. And now, early in 2022, we’re still seeing elevated prices. As a consumer, you may need to adjust your activities somewhat, but as an investor, how should you respond to inflation?
First, it helps to know the causes of this recent inflationary spike. Essentially, it’s a case of basic economics—strong demand for goods meeting inadequate supply, caused by material and labor shortages, along with shipping and delivery logjams. In other words, too many dollars chasing too few goods. Once the supply chain issues begin to ease and consumer spending moves from goods to services as the COVID-19 pandemic wanes, it’s likely that inflation will moderate, but it may still stay above pre-pandemic levels throughout 2022.
Given this outlook, you may want to review your investment portfolio. First, consider stocks. Generally speaking, stocks can do well in inflationary periods because companies’ revenues and earnings may increase along with inflation. But some sectors of the stock market typically do better than others during inflationary times. Companies that can pass along higher costs to consumers due to strong demand for their goods—such as firms that produce building materials or supply steel or other commodities to other businesses—can do well. Conversely, companies that sell nonessential goods and services, such as appliances, athletic apparel and entertainment, may struggle more when prices are rising.
Of course, it’s still a good idea to own a variety of stocks from various industries because it can help reduce the impact of market volatility on any one sector. And to help counteract the effects of rising prices, you might also consider investing in companies that have a long track record of paying and raising stock dividends. (Keep in mind, though, that these companies are not obligated to pay dividends and can reduce or discontinue them at any time.)
Apart from stocks, how can inflation affect other types of investments? Think about bonds. When you invest in a bond, you receive regular interest payments until the bond matures. But these payments stay the same, so, over time, rising inflation can eat into your bond’s future income, which may also cause the price of your bond to drop—a concern if you decide to sell the bond before it matures. The impact of inflation is especially sharp on the price of longer-term bonds because of the cumulative loss of purchasing power.
However, Treasury Inflation-Protected Securities (TIPS) can provide some protection against inflation. The face value, or principal amount, of each TIPS is $1,000, but this principal is adjusted based on changes in the U.S. Consumer Price Index. So, during periods of inflation, your principal will increase, also increasing your interest payments. When inflation drops, though, your principal and interest payments will decrease, but you’ll never receive less than the original principal value when the TIPS mature. Talk to your financial advisor to determine if TIPS may be appropriate for you.
Ultimately, inflation may indeed be something to consider when managing your investments. But other factors—especially your risk tolerance, time horizon and long-term goals—should still be the driving force behind your investment decisions. A solid investment strategy can serve you well, regardless of whether prices move up or down.