Core Concept 3 - Inflation noise

Coming back to my "Core Concept" series, I thought I'd spend a little time looking at the implications for inflation on your investment decisions. With the near-constant mention of the term, I thought I would be useful to look at this in a bit more detail.

Inflation seems to make sense intuitively. After all, when prices change it's hard not to notice it. Recent talk has been about the spectre of "deflation", where prices spiral down a la Japan lost decade. The behaviour of the Japanese makes sense - if you know prices are going to fall, you'll wait a week or so expecting the price to fall. When that takes place, you decide to wait a little longer for another price cut. And so on, until you enter a deflation spiral.

This fear has haunted the Fed and other central banks, as well as governments, and is behind the recent stimulus packages to kick spending up.

What people don't always appreciate is that "inflation" figures are a very coarse approximation. They are based on a basket of goods that are deemed representative of the population, but your personal inflation rate might be very different from (say) the CPI. This is because the split of your expenses (say % on food, energy) may vary a lot from the average.

From an investment perspective, inflation can be very destructive. After all, if a dollar suddenly buys you less, you need your investments to earn more to make up the shortfall. Too much inflation destroys your purchasing power. Too little, and the economy may start to slow.

So how do you defend yourself from inflation? Stocks have long been touted (and I use the term deliberately) as a way of hedging inflation. But it's not strictly true. Take a single company as an example. If it can pass 100% of a rise in inflation to its customers without hitting the bottom line, then you are effectively hedged. However in reality, to stay competitive, firms can't always up their prices, so the rise in costs into their profits, hence earnings, hence your stock value.

Bonds are normally poor at inflation control, as they are fixed return instruments. The exceptions are inflation-linked bonds, such as TIPS and Index-Linked Gilts. However don't expect a perfect hedge, as their payments are keyed off an official rate (CPI) that might not be your personal inflation rate.

Over a long term, real assets such as property do tend to track inflation, but again you can't take it as a given that it will be a perfect correlation. So in summary, inflation is something you have to factor into your portfolio decisions, but don't assume that simply buying inflation-linked instruments alone will work. It makes sense to have some exposure to them, but it ain't a panacea.