Inflation Uncertainty and Portfolio Diversification

Inflation is the overall rising of prices. This can happen when demand goes up, or supply goes down — for example, if supply chain issues cause a material shortage. Or the economy is booming, and consumers have excess income to spend.

Obviously most consumers don’t like higher prices, and if they rise disproportionately to income, it can have a devastating impact. When prices go up but wages stay the same, suddenly you can’t afford the same things. If it gets too out of whack, it can affect your ability to survive and feed your family.

Businesses might initially like being able to charge more, but if prices are rising all the way up the supply chain, they don’t make any additional profit. And if consumers stop buying, companies go under. The same thing is happening at the government level as countries around the world try to do business with each other.

No matter where you fit in this picture, it’s important to prepare your finances and plan for the inevitability of inflation.

How Often Does Inflation Occur?

What goes up must come down. But when we’re talking about economic conditions, what goes down also must come up. It’s not like dropping rocks off a cliff; it’s like riding the waves on a surfboard. And there are patterns of when and how the economy changes.

The Federal Reserve (or Fed) has a target rate of 2% inflation year over year, which is a natural increase in cost of living. If inflation deviates from that, the Fed will try to make corrections. Inflation typically happens when interest rates go down, so you will see a rise in interest rates, based on the federal funds rate, to counteract inflation. The Fed also might increase taxes, reduce spending, decrease the money supply, or impose price caps, although not all these methods are equally effective.

Wartime historically has tended to go hand-in-hand with inflation, with drastic price jumps common after the war ends. So have surges in the price of oil (or declines in oil production). But as the U.S. has started producing more of its own oil instead of relying on imports from the Middle East, and expanded resources to include renewable energy sources like wind and solar, the worldwide price of gas no longer has such a dominant effect on our economy. In addition, war is no longer something that consumes the entire country, with government rations on food and other necessities that lead to a post-war boom.

However, that same type of ration scenario occurred during COVID-19 when people were quarantined in their homes and stores had to shut down. So the same type of inflationary explosion also happened when restrictions were lifted.

How Does Inflation Impact Personal Finance?

Inflation affects everyone. And it absolutely impacts your personal finances.

When things cost more, that affects your purchasing power — meaning the same amount of money buys you less. That in turn reduces your ability to save and plan for the future on several fronts.

• Higher prices mean you can’t afford as much
• Taking care of your family becomes more difficult
• You have less money for savings
• It’s hard to build an adequate emergency fund
• You don’t have as much money for investments
• It’s hard to put away enough for retirement
• Delayed retirement means working longer
• Work can become more difficult as you age

Why Portfolio Diversification Is a Great Tool for Offsetting Inflation

Have you ever heard the phrase, “Don’t put all your eggs in one basket”? In the investment world, that’s a great metaphor for portfolio diversification, which means not putting all your money in one asset.

When considering investments, it’s important to take inflation into account. Let’s say you have a long-term investment earning a fixed rate of 5%. If inflation is at 3%, your actual return on that investment is only 2%. Obviously getting a higher rate of return will help offset that, but higher interest rates typically mean higher risk. Lower-risk investments are less likely to lose money, but they also usually come with lower ROIs.

If you’re starting out as an investor, consider how risk-averse you are. But either way, a great portfolio diversification strategy is to put some of your money in each of three buckets: low-risk, medium-risk, and high-risk investments. That way you can get the best of both worlds in terms of safety and return.

In addition, investing in a variety of asset classes reduces the chance that you lose money on all of them. You might choose to invest some money in real estate, some in commodities like gold or oil, and some in the stock market. You can also choose pre-diversified investments like mutual funds or exchange-traded funds (ETFs), both of which are collections of assets or stocks from different companies.

These strategies offset inflation because the chance of all your investments in every category being wiped out is pretty slim. You potentially end up with some high-interest returns, and your lower-interest investments are almost guaranteed to pay off, even if it’s just a little more than the rate of inflation.

What Does Portfolio Diversification Entail?

Portfolio diversification could look like investments in different asset classes, different risk levels, different performance periods, or any combination of those. Experts typically suggest having a majority of investments in a range of stocks. Stocks can be a good hedge against inflation because their prices often change with the market, in line with inflation. But stock values can also fluctuate unpredictably, so you should pair them with some investments in fixed-rate assets like bonds. A 60/40 split is a good ratio, or you can go a little higher on the stocks, like 70/30.

If you have a retirement fund, often the fund manager will create a diversified portfolio for you, based on your risk aversion. If you like to roll the dice hoping for a bigger return, your portfolio will have more stocks in it. But if you want to play it safe, you’ll have more bonds or other “safer” investments.

Combining Portfolio Diversification With Strategic Savings

Besides traditional investment vehicles, you can combine your portfolio diversification strategy with high-yield savings options. Most banks offer FDIC-insured deposits, which are relatively safe — but “high-yield” is relative because even the highest-yield savings account probably won’t give you as high a return as a risky stock might. Then again, the savings account has a guaranteed interest rate, and the stock could go up or down.

Some options for making a higher-than-normal return on your savings include high-yield savings accounts, high-yield certificates of deposit (CDs), and other CD variations like bump-up CDs. While jumbo CDs require a larger minimum deposit, you can find alternatives that fit any amount of savings you might have.

As long as you’re earning a rate of interest that’s higher than the rate of inflation, all of these products can nicely complement a diversified portfolio. But it’s important to shop around and find the best rates before committing your funds.

Some strategic timing could also come into play. As you might realize by now, the interest rates on savings accounts and CDs are also going to be affected by the Fed rate. During periods of high inflation, that’s actually a good thing, because it means the rate you’re earning is going to be higher.

Portfolio Diversification for Different Income Brackets

Obviously the amount of money you have for investing is going to affect the types of investments you can make. While it’s possible to get started with just a little bit of money, those who have more funds are typically able to make higher returns just based on sheer volume.

If you’re in a higher income bracket, consider going for a jumbo CD or jumbo high-yield savings account. Even though these products require a higher minimum deposit, you can also expect a higher interest rate, and the amount you make long-term will likely be more.

In addition, more wealth gives you the ability to try out higher-risk stocks and other volatile assets like cryptocurrencies without fear of wiping out your entire savings. You can also pay someone to do your investing for you so you’re not trading time for money. Then any return you net becomes passive income.

If you’re in a lower income bracket, consider getting started with fractional shares, which allow you to purchase small portions of stocks or crypto without committing a large amount of money. You can still have someone do the investing for you, but choosing that service as part of your investment program will prevent you from having to pay out of pocket for it. For example, retirement funds like a 401(k) or IRA often come with investment management.

Types of Inflation

Not all inflation is created equal. There are actually three types of inflation: demand-pull, cost-push and built-in inflation. And sometimes all three occur at the same time.

• Demand-pull inflation happens when the demand for goods and services drives up their prices. This can happen when income levels increase, and people have more to spend.
• Cost-push inflation occurs when material costs go up, causing businesses to raise their prices. Sometimes this happens as a result of demand-pull inflation.
• Built-in inflation is based on the expectation that prices will naturally rise. Workers ask for more money through cost-of-living increases, employers raise prices to maintain profit, workers spend more, material costs go up, and the cycle continues in a self-fulfilling prophecy.

How To Diversify Your Portfolio for Different Types of Inflation

Since there are different types of inflation, there are also different portfolio strategies to deal with them.

• Demand-pull inflation affects business valuation through demand for their products, so investing in shares of companies could be a good idea.
• Cost-push inflation affects the prices of goods, like oil and natural gas. So investing in commodities would be a good strategy if you can ride the wave up.
• Built-in inflation will always happen, and stocks are one of the best ways to hedge against it. So investing in the stock market is a great addition to your portfolio.

How Have Strategies for Portfolio Diversification Shifted?

Some of today’s popular portfolio diversification strategies didn’t used to exist. Mutual funds were created in the 1920s, but became more popular in the ‘70s with the introduction of variations like index funds and no-load funds. Then ETFs started stealing the spotlight the ‘90s. And cryptocurrency only became a thing with the invention of Bitcoin in 2008. So we have plenty of options now that our parents and grandparents didn’t always have.

There’s no reason to expect this trend to end any time soon. New financial products, new methods and new strategies are being created all the time, so 50 years from now this process is likely to shift even further. At this point we can only really guess … but it’s a good bet that it won’t be exactly the same as current best practices.

Other Financial Strategies to Prepare for Inflation

Beyond portfolio diversification, there are other financial strategies you can use to prepare for inflation.

Budgeting is one thing every financial expert will always tell you to do. It’s not necessarily fun, but you need to understand how much you have coming in and going out each month in order to plan for price increases while still having enough left over.

In your budget, consider:

• Grocery costs and areas you can cut back or save more
• Gas prices and how much driving you need to do
• Clothing prices and how many pieces you need
• Current income and how you can increase or maximize it

Carefully choosing a credit card that gives you cash back in the categories you frequent is another great way to make your money go a little further. Just be sure to pay off your bills instead of carrying a balance that could get out of control with interest charges.