Smart Investing During Inflation: Where to Put Your Money

Investors invest their money to protect it from inflationary pressures and to earn returns. Frankly speaking, many investors ignore the first aspect and generally focus on the returns.

If you are new to investing, you may not yet have faced the question of where to invest during periods of inflation. Making smart investment choices is crucial for allocating your hard-earned money across various asset classes, considering both your needs and risk tolerance.

Before diving deeper, let’s first understand inflation. Inflation is the general increase in the prices of goods and services over a certain period, which reduces the purchasing power of currency. A well-known example is the rising cost of petrol, which many of us buy regularly for our cars and bikes. Years ago, the price of a Liter of petrol was about half of what we pay today. Not only has the price increased, but the purchasing power of the same Rs 100 note has also decreased.

It may have crossed your mind, what causes inflation? Inflation occurs when there is an imbalance between demand and supply in the economy. This imbalance can result from abnormally high demand or disruptions in the supply of goods and services.

Obviously, investors invest their money to protect it from inflationary pressures and to earn returns. Frankly speaking, many investors ignore the first aspect and generally focus on the returns.

First, one should be aware of three factors to keep in mind while thinking about investing during inflation.

Time: This is the most important factor because beating inflation requires time; in the short run, it is challenging to achieve this. Just as the impact of inflation can be more easily identified over the long term, it also takes time to overcome it. Attempting to beat inflation in a short period, such as 3 to 6 months, is difficult.

Portfolio: Generally, investors make the mistake of thinking that a portion of their corpus has beaten inflation by generating returns above the inflation rate. For example, they may invest some portion of their capital in equity and focus solely on that investment, assuming it will beat inflation while ignoring the rest of their portfolio. The approach should involve evaluating the entire portfolio to determine whether it is beating inflation, rather than assessing investments in isolation.

Returns: The returns should exceed the inflation rate, meaning that real returns (the returns generated by asset classes minus the inflation rate) must be positive. This can only be achieved through proper asset allocation that aligns with the appropriate risk and return profile, along with a long-term investment horizon.

Now that we understand the factors to consider while investing during inflation, let's explore the options available for investing money in an inflationary environment.

Equity: Investing in company stocks has historically yielded annualised returns that exceed inflation. For instance, the Nifty 50 index achieved an annualised return of 15.30 per cent over the past five years. Assuming an average inflation rate of 4 per cent per year and even if your portfolio stock investments generate annual returns of 8 per cent, your returns would still be double the inflation rate. This indicates that your corpus is growing rather than incurring losses due to inflation. Historically, equities have provided the best protection against rising inflation.

Inflation-Indexed Bonds; Inflation-indexed bonds or IIBS is a type of bond designed to protect investors from rising inflation. As inflation erodes the purchasing power of money, it can adversely affect individuals and create economic instability. However, these bonds serve as a shield against inflation by offering a fixed rate of return that accounts for changes in the inflation rate. Inflation bonds differ from traditional bonds in their interest payments. Both the principal and interest are adjusted for inflation based on the Consumer Price Index (CPI), ensuring the investment's real value is preserved. A fixed interest rate is set at issuance, which is combined with the inflation rate to calculate the total interest payment.

Commodities: Investors may consider investing money into various commodities like metals, oil, natural gas, sugar, and so on as these instruments are considered as inflation hedged instruments. It doesn’t mean that one should solely invest in the commodities and allocate 100 per cent of their investment amount into commodities instead should allocate some portion to gets protected from the inflationary pressure during high inflation. Before investing in commodities, investors should be aware that they are highly volatile, and investor caution is advised in commodity trading.

Bonds with Floating Interest Rates: Investors may consider opting for floating-rate bonds during inflation, as rising inflation typically leads to higher interest rates and increased returns. These bonds adjust their interest rates periodically based on a benchmark, allowing investors to benefit from higher yields in a rising rate environment. They serve as a hedge against inflation and increasing borrowing costs. However, investors must be aware that if benchmark rates decline, yields may drop, potentially underperforming fixed-rate bonds.

Precious Metals like Gold: Gold, often referred to as the yellow metal, has been one of the safest and most common inflation hedges that investors have relied on for centuries. Investors can add gold to their portfolio in various ways, including through gold ETFs and mutual funds. Additionally, you can invest in gold via Sovereign Gold Bonds issued by the Government of India, which are based on grams of gold and provide returns linked to the market value of gold. These investment options are generally preferred over holding physical gold or buying bullion, as they eliminate the need to manage physical gold.

Conclusion

Understanding how to invest during inflation hinges on identifying the right inflation-beating assets. Equity stocks, gold, commodities, and inflation-indexed bonds have historically proven effective as inflation hedges. By investing in these assets, investors can safeguard their purchasing power. It's important to recognise that business cycles including inflation and recession are inevitable parts of investing. The key lies in selecting appropriate assets and maintaining an optimised balance, which can help protect the value of your investments against the erosive effects of inflation.

Disclaimer: The article is for informational purposes only and not investment advice.