What is inflation? How will it affect your portfolio in the coming years?

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So what is inflation, you ask? In simple terms, it is the rate at which purchasing power of a currency declines or the rate at which consumer products increases in value over time. For example, if the price of a loaf of bread was $1 last year, it now costs $1.05. The increase in value is caused by inflation. The cost of baking loaves of bread has gone resulting in a hike in the price of bread. Your $1 no longer buys you a loaf of bread. The value of the currency has decreased over time.

While it is easy for us to measure the price difference between a handful of products over time. But a loaf of bread is not the only thing we use in our daily lives. We use hundreds of items and host more than just the handful of services that contribute to our comfortable living. They include things such as food, grains, clothes, vehicles, electricity, water, and most modern entertainment software, to name a few.

Inflation on the macro-level aims to measure the overall impact of the price change in products in the market. The calculation of price variation between all products and services allows for a single value representation in an economy.

What caused the Inflation, or why prices of consumer goods have gone up since the beginning of the pandemic?

An increase in money supply in the market is the root cause of inflation. That is precisely what happened when coronavirus sent multiple economies into recession. Australia went into recession for the first time in March 2020 after almost thirty years because most of the businesses were forced to shut and lockdowns introduced in many parts of the country.

To combat its way out of recession, RBA(Reserved Bank of Australia) introduced stimulus packages to help pump money into the economy. At the time of this writing, Australia has pumped $291 billion into the economy in the form of stimulus checks and other relief efforts since the beginning of the pandemic.

But wait! How does that have anything to do with the rise in inflation?

Where do you think the RBA gets the money from? They print it, or better yet, they type it in their system, and there you go!

To help you understand the concept better, let’s use an example of seasonal fruit or vegetable. When avocado is in season, what happens to its market price? It decreases in value because of the relationship between demand and supply. When supply is more than the demand. The cost of avos decreases, and the same goes for when demand outweighs the supply, the price will increase.

There are three types of inflation.

  1. Demand-pull – This occurs when the demand for goods and services exceeds the rate at which those services are produced.
  2. Cost push – This occurs when the cost of raw material rises in price, resulting in the more expensive finshed product.
  3. Built-in inflation– This type of inflation is build upon the adaptive expectation that current infation rate will continue at the same pace in future as well.

How does inflation effect your portfolio?

While built-in inflation is considered good for the share market as a whole. As it is considered as the indication of economic constant growth in the market. However, sudden jumps or unexpected rise in inflation is negative. The negative effect may vary from sector to sector in investment classes. Higher inflation is considered negative because it is an indication that the borrowing cost is likely to increase, raw products and labour will likely increase, and an overall decline in earnings.

There is a company behind the stocks we buy if there is a sudden jump in inflation. It’ll increase the cost of production because the business costs more to operate now than it did before the sudden rise in inflation. As mentioned above, not all sectors will have the same impact.

People need to eat regardless of how high the inflation is. To dampen the impact of inflation, one can diversify their portfolio between sectors.

Have a mix of value and growth stocks in your portfolio. Inflation tends to affect growth stocks more than value stocks. In times of rising inflation, having a mix of solid growth and value companies can strengthen your portfolio.

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