Important: This article is for general guidance purposes only and should not be considered investment advice. If you are unsure about the suitability of an investment, please seek out advice. When you invest, your capital is at risk.
With news headlines warning of rising inflation, a cost-of-living crisis and rising energy bills, you could be forgiven for thinking that investing is futile. There are steps, however, you can take to beat inflation. Here, we look at what causes inflation and the best places to direct your cash when living expenses are spiraling.
Remember, no investment can ever be 100% inflation proof – but with a little knowledge, you’ll hopefully minimise its effects.
What is inflation and how does it impact investing?
Noticed your weekly grocery shop costing more recently? That’s inflation. It’s when the prices of goods and services creep up to the point where it takes more money to buy the same thing than it used to.
In the UK, inflation is measured by the consumer price index (CPI), which tracks the cost of a typical basket of household goods and services: cars, holidays, bread, utility bills and more. The exact list is tweaked each year as trends shift, which means that CDs, men’s suits and doughnuts no longer feature, but smart speakers, sports bras and veggie sausages do.
Inflation isn’t all doom and gloom
Despite the sense of financial apocalypse that the word ‘inflation’ often brings, it’s reassuring to know that a bit of inflation is actually not unusual and you’ll typically see prices rise a percent or two per year in most countries. It’s why it costs more to buy the chocolate bars you ate as a kid today than it did during your childhood.
However, when inflation shoots up to double digits – as we’ve seen recently – it’s sensible to keep an eye on your potential returns and investments.
"Several investment types can potentially give you inflation-busting returns."
Why do we get high inflation?
There are various reasons, some of which we are experiencing now. Rising production costs – from raw materials to higher wages – have an inevitable knock-on effect on the prices you see on the shelves. Supply shortages (such as those we’ve seen in the wake of the Ukraine war) also mean that retailers struggle to keep pace with demand – and prices are pushed up.
Another reason is increased money supply – that’s the total amount in the economy, from cash to bank accounts. During times of financial hardship, one strategy by central banks is ‘quantitative easing’, where more money is pumped into the economy to stimulate it.
The goal here is to encourage more spending and dodge full-on recession. However, having more money in the economy, alongside greater consumer demand, can encourage prices to spike, again leading to, yep, you got it, higher inflation.
What does that mean for my investments?
If your investments give you higher returns than the current inflation rate, that means that inflation won’t eat away at the value of your overall portfolio. However, if they’re making less – say your savings account offers a 1% interest rate while inflation sits at 7% – you’re losing your purchasing power in the real world.
"Inflation can be beaten over the long run, but the trick is in knowing which investments may be inflation-proof"
Are any investment types ‘inflation-proof’?
Inflation can be beaten over the long run with the right investments. The trick is in knowing which ones.
Several assets can potentially give you inflation-busting returns, with some performing better in a ‘rising inflation’ environment (where prices and interest rates increase by bigger and bigger percentages over time – 1%, then 3%, then 5% per month, and so on). Then, there are other types that do better when there’s a ‘steady inflation’ situation (where prices increase by roughly the same amount over time, say 3% each year).
"Companies that make essentials like the humble toilet roll are more resistant to inflation"
Inflation beating investment one: Stock indices
You’ll no doubt have heard of the FTSE 100, an index that tracks the share performance of the UK’s biggest companies based on their market cap. The S&P 500 index is similar, featuring 500 leading companies in the US.
Investing in a stock index featuring ‘blue chip’ names (firms that make money and are well established) makes sense when inflation is riding higher than usual. Historically, the FTSE and S&P 500 have averaged returns of 7-10% per year, smashing the rate of interest on most high-street savings accounts. Saying that, past performance is not indicative of future results, so you need to bear that in mind.
Stock indices are also a smart inflation-fighting choice for ‘long-term investors’ or those preferring to ‘buy and hold’, rather than continually buy and sell shares. In other words, if you’re prepared to wait it out, long term you can rack up the benefits.
That said, stock indices tend to perform best when inflation is steady, but struggle more when inflation is rising, especially once interest rates inch above 6%.
Think about it – if a company is forced to raise prices because of inflation it will take in more revenue via sales. If prices become too high, however, its customers may decide not to buy its products, opting for either cheaper alternatives or going without. In such a scenario, the company’s sales will dry up and it’ll struggle.
Don’t forget, stocks are generally riskier than a standard savings account, as you’re not guaranteed a return, and shares go down as well as up.
Inflation beating investment two: Consumer staple stocks
Remember the great toilet roll shortages of 2020? It was a perfect example of why so-called ‘consumer staples’ can be a sensible place to put your cash.
Companies that make essentials like deodorant, cleaning products, toothbrushes and, yes, the humble toilet roll, are more resistant to inflation, since most people will buy their products no matter how stretched their funds. That means that companies can increase prices on that 12-pack of toilet paper as inflation rises, with minimal effect on sales or demand.
Thanks to the necessity of these items, you can see how investing in consumer staples can be a safe ‘hedge’ against rising inflation (a hedge being an investment strategy that reduces your overall financial risk).
Inflation beating investment three: Commodities
Remember the scene in Trading Places where crowds of stockbrokers yelled at the screen as the price of frozen orange juice tanked? Those folks were trading commodities, another interesting investment strategy when inflation strikes.
In essence, commodities are basic resources and raw materials that can be traded as goods, such as coffee, oil, wheat, sugar, butter or precious metals like gold.
The price of commodities is generally (though not always) closely tied to rising inflation, as they’re a component in other products – from the single origin beans in your flat white to the wheat in your sourdough loaf.
That means investing in commodities can be a smart move during periods of financial instability. When inflation is steady, though, commodities may be less effective.
Gold is famously touted as a hedge against inflation when prices shoot up, but the reality is that sometimes it works, sometimes it doesn’t. Oil, in contrast, has a better track record of moving higher alongside inflation, as it benefits from increasing economic activity, which is sometimes actually the cause of the inflation.
Still don’t know your agricultural crops from your elbow? One easy way to expose yourself to commodities can be investing in a commodity-focused exchange-traded fund (ETF). These are a ‘basket’ of different shares in one particular sector (gold, say, or crude oil).
Inflation beating investment four: REITs (real estate investment trusts)
Fancy owning your own property empire but don’t have the spare millions lying around to snap up that seaside hotel, chain of supermarkets or fancy apartment block? That’s where REITs come in.
These are funds that invest in the property market for you and buying shares via REITs gives you exposure to real estate that earns rental or management fees.
As we’ve seen over the last decade or two, investing in property can be a no-brainer way to make money because – over the long-run – property prices tend to increase along with steady inflation and often beat it. While returns vary by region and country, most averages put real estate appreciation at 3-4% per year, which outpaces low levels of steady inflation and interest rates.
Saying that, REITs aren’t necessarily a safe bet when inflation is shooting up at the speed of light, as we’ve seen lately. The reason for this is that as interest rates tend to rise, people can’t afford to borrow as much or to spend as much on rent. Property prices may be impacted as a result.
That said, REITs may still perform well in times of rising inflation, since rents will often go up to account for higher costs of living.
Inflation beating investment five: Bonds
If you’re wary about risk, then bonds might suit you. Often seen as sitting at the ‘safe’ end of the investment spectrum, these offer a predictable rate of return for a fixed term.
Although bonds aren’t going to give you stratospheric returns, they can still trounce inflation when it’s steady. As an example, if you buy a 3% bond but inflation is holding near 2% or below, you’ll be winning.
Bonds aren’t completely foolproof and can still lose you money in real terms. As an example, if you buy them when inflation or interest rates head upwards, suddenly hitting 4%, say, then that 3% bond is clearly no longer a great bet.
There are some bonds, however, that offer returns linked to inflation.
What investments typically perform worst during times of inflation?
The above are the types of investments that might just save you from inflations’ impact. But, which investments are less attractive when high inflation strikes?
Cash
Cash is generally regarded as one of the worst investments during high inflation for good reason. A short-term savings account paying a microscopic amount of interest will be losing you purchasing power. Yes, we all need some easy-access cash on hand for day-to-day expenses and outgoings but it’s still a good idea to invest and grow.
Certain bonds
As mentioned above, bonds can make you money when inflation is steady but the more interest rates nudge up in response to soaring inflation, the less attractive they look. In short, making 2% on a bond is a winner when interest rates are 0.5%: less so when they go higher.
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