Last week we talk about fundamental analysis. One of the factors analysed by fundamental analyst is economic factor.
Two words frequently encountered in economic reports these days are Inflation and Stagflation. What exactly do they mean?
Very often when we read reports and analysis, the US market is mentioned. The US market exerts no small amount of influence on other markets, especially those in Asia that depended on export to the US.
The danger of Inflation in US is highly anticipated. Inflation is the sustained increase in the average level of prices of a basket of goods and services. Do you see oil prices going up? How about transportation, groceries? Many believes that the consistently high oil price will trigger an inflation.
Some forecasted that we may even see stagflation in 2007. Stagflation = inflation + slowing economic growth. This was what happened during the 1970s, when world oil prices rose dramatically.
How does all these affect investing? Read on to find out.
Inflation and Stagflation affects Investment in a two ways.
First, as a result of raising prices, the same dollar is buying less and less things. In another word you will need more dollars to buy the same thing.
From an investment return prespective, the same investment with inflation considered would now have to return more in order to match the return without inflation.
Consider this, you are targeting to go on a holiday with your investment return at the end of year. Now inflation sets in and the holiday now cost 1.5 times as much. Correspondingly your investment would have to return 1.5 times as much in order to cover for the holiday.
Second, certain class of investments are affected more by inflation than others. When inflation is mention, interest rates are also mentioned in the same breath.
Often we heard of the US Fed adjusting the interest rate taking into consideration economic factors including inflation. (Note that this interest rate is not quite the interest rate you get from the bank. I might talk more about this in future.)
This gives you some clue as to the relationship of interest rate and inflation.
Now, what class of investment are affected by interest rates?
Fixed-income investment and bonds are most adversely affected. This is because while overall prices increases, the return remain a fixed precentage.
This is not an attempt to discredit fixed-income investment, they do have their place. More importantly it is to know your investment objective and the choosing the right investment class or portfolio.
Since I invest largely in unit trust (mutual funds), I like to point out that buying a bond fund in such scenario might help. The fund manager will hopefully manage a portfolio of bonds and use strategies to reduce the effect of inflation. (I not suggesting you go out and buy a bond fund now though.)
After reading this, you should have some insight into inflation, stagflation and their effect on investing. Like many things about investing, it is about understanding the underlying factors and investing accordingly.
This article is part of a regular column on investing by Ken of 59Ideas published on Invest Insight. You may copy and use this article if you retain this message.
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