Vantage Point: Economic Outlook  

Investment vs inflation risk: the importance of staying invested

  • Explain the impact of inflation on portfolios
  • Identify the current risks in one's portfolio, given high inflation
  • Describe the kind of approach investors should take with their portfolio
CPD
Approx.30min
Investment vs inflation risk: the importance of staying invested
(Bloomberg/Dreamstime)

Since 2008, we have lived through what might be described as an 'easy money' era. 

After the global financial crisis of 2008, keeping interest rates near zero served to ease financial pressure on governments, banks and households alike. It also had the effect of supporting asset prices.

What followed was a golden period for asset owners, who could borrow more cheaply and earn higher returns on risk assets. The benign liquidity environment made investing look easy – all risk assets, across asset classes, and also highly speculative ones, delivered returns.

The current period of inflation

However, since October 2020, a combination of factors has brought about some significant changes to the inflationary regime. These include:

  • the rapid economic restart as pandemic-related restrictions eased, prompting severe disruption to supply chains;
  • post-pandemic pent-up demand pushing up global energy prices; and
  • geopolitical tensions inflamed by the Russia/Ukraine conflict and related sanctions affecting the supply of energy and key commodities. 

The combined effect of the above has led to widespread supply-side price inflation across energy, raw materials and manufacturing costs. 

The importance of staying invested

The current slew of negative political and economic news understandably impacts risk appetite for investors and managers alike. However, staying the course while adapting to the context is important. There are three reasons why:

  1. Time in the market, not timing the market, delivers returns.
  2. Compounded long-term returns tend to outweigh the losses prompted by episodic crises.
  3. In the context of high inflation, cash is riskier than equities for capital preservation.

Trying to time the market to buy before 'good' days and sell before 'bad' ones is impossible. Staying invested is critical to capture all the good days that drive returns, but inevitably that means accepting some bad ones too. While it can be uncomfortable, it is better to stay invested.

And while it is never comforting to see negative returns as investors have done recently, it is important to put things in perspective. If we look at stock market returns since December 2007 – thereby capturing the financial crisis, the Eurozone crisis, the taper tantrum, Brexit, Covid and war – both cumulative and annualised returns remain strong.

Investment risk vs inflation risk

It is important to consider 'risk' in a broad sense: not just investment risk, but inflation risk too, in the context of time. The difference is outlined below:

Relationship between risk and time during a higher inflation regime

 

Short-term

Long-term

Cash

Lower risk

Higher risk

Equities

Higher risk

Lower risk

Source: Elston research, for illustration only

Investment risk, often measured in volatility, is the flip side of returns. So in a benign market environment, when things are going well, volatility is your friend – you receive a reward for the risk taken. But in a malign market environment, when things are getting difficult, volatility is your foe – you receive a negative return for the risk taken.

Higher risk assets such as equities may appear volatile and will fluctuate. However, in an inflationary regime, they are safer than cash over the medium to long term.

By the same token, lower risk assets such as cash may appear safe and not fluctuate, but in an inflationary regime cash is high-risk over the medium to long term as its purchasing power is destroyed by inflation. 

The volatility of cash is not, in fact, zero, but is impacted by the volatility of inflation. And when inflation volatility is high, the riskiness of cash is high. In this respect, understanding the difference between investment risk (volatility) and inflation risk (loss of purchasing power) over time is key.