For the past few years, the US government has increased its deficit spending by more than a trillion dollars a year. This amount of spending is unprecedented. For the current year, our elected officials are talking about a budget which includes approximately 1 ½ trillion in deficit spending. Pumping dollars into the economy at this level is similar to adding a gallon of water to a can of orange juice. As more and more dollars are poured into the economy, the dollar's value is diluted. This dilution increases inflationary pressures which in turn have an impact on your investments.
In an inflationary environment, people who live on a fixed income are typically hurt the worst. As prices increase, they are not able to buy as much as they did before. Creditors with contracts which include fixed interest rates are also negatively impacted. Suppose you were a creditor and you made a loan. The loan has a fixed annual interest rate of eight percent. Inflation was five percent when you made the loan. This means your real rate of return was three percent. If inflation increases to 10 percent next year, your real rate of return would be negative two percent. On the other hand, if you're not the creditor but the borrower, inflation allows you to pay your fixed debt payments with cheaper dollars. You'll be able to pay off your debt faster with diluted dollars.
Investing in stocks may not be as bad as you might think. If a company is run by competent managers who increase prices as costs increase, the company's revenues and earnings should increase as inflation increases. Be sure to invest in stocks that have returns higher than the inflation rate. You can also purchase inflation protected investments like inflation indexed bonds and Treasury Inflation Protected Securities (TIPS). These investments are impervious to inflation risk because their rates move with inflation. An investment portfolio with fixed income securities that are not protected against inflation will see a deterioration of value. If your portfolio has fixed income securities that aren't inflation protected and you expect higher inflation in the future, I recommend moving your money out of these fixed income securities.
In a high inflationary environment, investors look more for investments with a short-term maturity horizon. Investors tend to shy away from investments with long-term maturities due to the increased uncertainty. Because inflation makes it difficult to predict future expectations, investors are unwilling to enter into long-term contracts. Over time this unwillingness has a negative affect on economic growth.
Investors also utilize "stores of value" to hedge against inflation risk. Throughout history precious metals have been used as stores of value. People purchased metals like gold and silver. They have also used other stores of value like real estate, works of art, precious stones, and livestock. Eventhough the value of these commodities change over time, they have shown to retain some value in almost any situation.
In an inflationary environment, people who live on a fixed income are typically hurt the worst. As prices increase, they are not able to buy as much as they did before. Creditors with contracts which include fixed interest rates are also negatively impacted. Suppose you were a creditor and you made a loan. The loan has a fixed annual interest rate of eight percent. Inflation was five percent when you made the loan. This means your real rate of return was three percent. If inflation increases to 10 percent next year, your real rate of return would be negative two percent. On the other hand, if you're not the creditor but the borrower, inflation allows you to pay your fixed debt payments with cheaper dollars. You'll be able to pay off your debt faster with diluted dollars.
Investing in stocks may not be as bad as you might think. If a company is run by competent managers who increase prices as costs increase, the company's revenues and earnings should increase as inflation increases. Be sure to invest in stocks that have returns higher than the inflation rate. You can also purchase inflation protected investments like inflation indexed bonds and Treasury Inflation Protected Securities (TIPS). These investments are impervious to inflation risk because their rates move with inflation. An investment portfolio with fixed income securities that are not protected against inflation will see a deterioration of value. If your portfolio has fixed income securities that aren't inflation protected and you expect higher inflation in the future, I recommend moving your money out of these fixed income securities.
In a high inflationary environment, investors look more for investments with a short-term maturity horizon. Investors tend to shy away from investments with long-term maturities due to the increased uncertainty. Because inflation makes it difficult to predict future expectations, investors are unwilling to enter into long-term contracts. Over time this unwillingness has a negative affect on economic growth.
Investors also utilize "stores of value" to hedge against inflation risk. Throughout history precious metals have been used as stores of value. People purchased metals like gold and silver. They have also used other stores of value like real estate, works of art, precious stones, and livestock. Eventhough the value of these commodities change over time, they have shown to retain some value in almost any situation.
Author: Joseph is a certified and accredited business appraiser with Hyde Valuations, Inc. He has performed appraisals and valuation services. He also writes and speaks on business and valuation topics. For more information please visit: http://www.superiorvaluations.com
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