There probably was a time you didn't think much about inflation. Now it's hard to not think about it. It seems like everything is more expensive these days, from airplane tickets to used cars to the snacks your family craves.
In these uncertain economic times, you may worry about the health of your finances. And you're not alone. According to
What causes inflation?
Inflation occurs when there's an imbalance of supply and demand for goods and services. When total demand for those goods and services exceeds total supply, prices tend to rise. They tend to drop when the opposite happens.
Inflation was relatively low in the U.S. economy for three decades. But in 2022, we've experienced the highest inflation increases in
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63% of people surveyed said inflation is pushing them off track financially.
What does inflation do to the stock market?
Rising costs and uncertain revenue growth can take a toll on corporate profit margins, and stock prices can fall in response. On a broader scale, high inflation creates unknowns about future interest rates, and that uncertainty often contributes to market volatility.
Ultimately, it's tough to definitively say how inflation impacts stock market returns; inflation is just one of many variables at play. The repercussions of the COVID-19 pandemic are still weighing on the market, for instance, and so is global economic uncertainty created by Russia's war in Ukraine. Amid persistent inflation, the stock market experienced
One way inflation comes into consideration is the
Why this could be a good time to invest in stocks
Yes, the stock market's ups and downs can be difficult to stomach, but holding equities actually could be beneficial for you right now for a couple of reasons.
For one, stocks are considered to be a hedge against soaring prices. They could help you equal or outpace the average rate of inflation over the long term. In fact, though you may not have thought much about it, stocks have been hard at work doing this for investors for quite some time.
Think about it: The S&P 500, an index that represents the average performance of a group of 500 large capitalization stocks,
Also, since sharp rebounds often follow periods of decline, you could be well rewarded for staying strong with stocks. Following the 10
Growth vs value stocks: What you should know
Notably, some stock styles shine brighter in an inflationary environment than others. One reason has to do with that connection between inflation and rising interest rates. When interest rates are high, value stocks tend to perform better than growth stocks.
How growth stocks work
Growth stocks are typically companies whose shares are expected to grow at a faster rate than the market average. There are a few considerations to keep in mind about this type of investment:
- Growth stocks attract investors who are willing to pay a higher price now because they have big hopes for the company's future growth and the payoff they may get when they sell their shares.
- However, these stocks do not typically pay dividends, meaning being a shareholder wouldn't offer you a means of regular income from your investment.
- Growth stocks generally have a large presence in their industry. Tesla is one example of a growth stock—it dominates the electric car industry and is expected to continue to outperform the market average.
How value stocks work
Value stocks, on the other hand, tend to be cheaper—they are companies that have a low price-to-earnings (P/E) ratio, which compares a company's current share price to its earnings per share. Here's what to know about value stocks as an investor:
- Value stocks have a low P/E ratio, which might seem like a bad sign, but it could mean that a company's stock is undervalued. A low P/E is not always an indication of poor company performance.
- When considering value stocks, it's important to look at the company's fundamentals—earnings, sales, dividends, etc.—to match the lower priced shares against actual performance. This will give you an idea of whether an undervaluation is the cause for the share price.
- Value stocks often pay out
dividends and generally lead to higher returns over the long-term.
- Many value stocks belong to mature but steadily growing companies with stable revenues and earnings, with Berkshire Hathaway being one example.
What could happen to value stocks as rates rise?
The growth style has generally outperformed value over the past decade. While the Pure Growth index earned a 13.05% 10-year annualized return through late August 2022, the Pure Value index
Inflation and interest rates have introduced a plot twist. As of late August 2022, the value index has a one-year return of 2.85% while its growth counterpart has a dismal -18.35% return.
Value investing can be a smart strategy in a high-inflation, high-interest-rate environment. Though all investments have risk, buying undervalued stocks of companies with strong business fundamentals can be less risky and costly than buying growth stocks. High interest rates can negatively impact the above-average growth of those companies that investors are banking on.
However, there's not always a clear cut line of which stocks belong in which category. The internet is full of opinions about where Apple falls, for instance.
Likewise, it's become hard to assign sectors to one style or the other. Consider the
Factoring inflation into a stock's rate of return
With inflation so prominently in the picture, it's important to understand the difference between a nominal rate of return and a real rate of return.
A stock's nominal rate of return is the net gain or loss over a time period before adjusting for factors like inflation and taxes. While it can help you compare the performance of various stocks, it doesn't provide the whole picture you need to properly evaluate an investment.
A stock's real rate of return accounts for factors like inflation and taxes. The real rate of return is lower than the nominal rate of return when inflation is present.
Here's an illustrative example that uses simple calculations and ignores taxes and other factors: A stock that generates a 9% return over one year has a 9% nominal rate of return. However, when the inflation rate is 5%, the real return rate is only 4% (9% minus 5%).
Tips for investing in the stock market during periods of inflation
While it may not be the most fun time to be an investor, high inflation doesn't need to throw your financial goals off course. Here are some tips to consider:
Steer clear of emotional decisions
Watching your account values fluctuate greatly is certain to cause some
Get strategic about your investment strategy
Consider a
On that note, remember that a slumping stock market can provide an opportunity to find good stocks that are essentially on sale. (Who doesn't like a sale?)
Diversify & rebalance your portfolio
As in times of low inflation, it's wise to build and maintain
Your investment portfolio isn't set and forget. Be sure to review how your investments are working for you with a financial advisor. If your original target allocations of stocks, bonds and cash have shifted in a way that no longer match your risk tolerance and investment objectives, it may be time to rebalance.
Don't make investment decisions alone
Clearly, inflation can add head-spinning complexity to investment decisions that can be hard to navigate in the best of times. Think about connecting with a