Inflation has had a negative impact on our budget and savings, from the items in your grocery cart to your expensive restaurant bill or your dream home becoming increasingly out of reach.
It’s critical to devise strategies to protect ourselves from the effects of inflation, especially as we approach retirement. Here’s how common stocks can help your portfolio combat the negative effects of inflation.
Selecting stocks to protect against inflation
To protect your assets, simply invest in securities that provide a higher return than inflation. The net return minus inflation is the real return. In other words, if your common stock portfolio yields 10% but inflation is 3%, the real return on your portfolio is 7%. It is simply a matter of gaining ground against inflation by earning a higher return than inflation.
Metro (TSX:MRU), with its 14% return year to date (YTD), is an example of a stock that has done fairly well. Grocery stores are able to pass on rising costs to customers, offsetting a decline in revenue.
Jeremy Siegel, an emeritus professor at the prestigious Wharton School of Business at the University of Pennsylvania, has demonstrated that long-term, real stock returns are remarkably consistent, even during periods of inflation.
According to the findings of researchers Jaffe and Mandalker, inflation has little effect on long-term stock returns.
How stocks benefit from higher prices
In an inflationary environment where prices are rising, businesses can pass on price increases to customers and consumers by raising the prices of the goods and services they offer.
Profits increase, as selling prices are raised to maintain profit margins. If profits rise, the stock price should rise as well.
This is the mechanism that makes common stocks such an effective tool for combating long-term inflation.
Although the mechanism is well-oiled in the long run, the investor should be aware that it is not so obvious in the short run, and that one may even experience the opposite effect at first. Three factors stand in the way of a perfect match between rising stock prices and rising inflation.
First, when inflation rises, central banks will raise interest rates in an attempt to reduce inflationary pressures. Higher interest rates create a headwind for equities, because they affect the supply-demand ratio. Instead, investments will favour the bond market at the expense of common stocks.
Second, because inflation causes interest rates to rise, the cost of capital rises temporarily. Companies will have to pay more to finance new projects such as a new production line, a new factory, or the acquisition of a competitor. This reduces short-term profits while increasing the value of common stock.
Third, while companies may raise their prices to offset rising costs, these increases take time to work their way through the sales cycle and onto the balance sheet.
Although inflation may appear to be harmful to the stock market in the short term due to increases in interest rates and the time required to complete a sales cycle, it can actually be beneficial, allowing companies to raise prices and profit margins. Rising profits eventually support positive stock market performance.