Everyone dreams of creating wealth through wise financial investments, but inflation can quickly cause these big dreams to become a distant reality. Imagine planning for your retirement and saving and investing in the stock market only to find that inflation has eroded much of the returns you were hoping to enjoy. Unfortunately, this scenario is all too common. Inflation adds to the price of goods and services over time, which means that you end up paying more for something than before.
As an investor, it’s important to understand how inflation affects your mutual funds and what investments you can make today that will provide adequate protection against its damaging effects in the future! With that being said, let’s take a closer look at inflation’s impact on your mutual fund returns and strategies you can implement to minimise its impact on your portfolio.
Impact on purchasing power
Inflation reduces the purchasing power of money. For instance, if you have invested Rs. 10,000 in a mutual fund that earned 10% per annum and inflation was 5%, your actual return adjusted for inflation would have been only 5% per annum. So, even though your mutual fund investment earned you a positive return, your actual return was eroded by inflation. This is referred to as the real or inflation-adjusted return.
Higher interest rates
Inflation also affects interest rates, which are typically adjusted according to the prevailing inflation rate or deflation in the economy. When inflation rises, so do interest rates as banks attempt to keep pace with the rising cost through high-interest rates. This dynamic can benefit investors who purchase bonds when interest rates are high but may be detrimental for those who hold securities in companies that need to borrow money at high rates to finance operations or expansion efforts.
Therefore, when you invest in mutual funds with bonds as part of their holdings, your return may be affected by rising interest rates due to inflation.
Inflation can also lead to increased volatility in the stock market, which can directly impact mutual fund returns. For example, if inflation leads to higher prices for goods and services, then companies’ profits could be affected due to higher input costs or lower demand from consumers who are feeling “price-squeezed”. This is because they now need to spend more money on basic necessities such as food and housing costs.
This could lead to decreased share prices for those companies whose profits are impacted by inflation, thus reducing the value of your investments in those companies’ stocks within your mutual funds.
Inflation can cause currency fluctuations, affecting international investments held within a mutual fund portfolio. If one country experiences higher levels of inflation than another country (where you hold international investments), then their currency may fluctuate, making it more expensive for you to purchase those investments when converting back into your home currency thus reducing potential gains from those investments.
To wrap up
The impact of inflation on mutual fund returns may not be something you can control. However, you can implement various techniques to hedge against the impact of inflation on your returns.
Diversifying your funds is one of the primary strategies, which means that you should not put all your funds in just one asset class. Instead, start an SIP or systematic investment plan in different asset classes such as equity, bond, and gold mutual funds. When necessary, rebalance your portfolio and consult a financial advisor to ensure it fits within your investment goals and risk tolerance.