What Does Inflation Mean for Your Investments?
By Georgia Holmes
Inflation can reduce the purchasing power of your money, even when your investments grow. Discover how it affects shares, bonds, cash and property, and how to plan for the long term.
Inflation affects more than the cost of your weekly shop or household bills. It can also influence the value of your savings, the returns you earn on investments and how much money you may need to fund your future lifestyle.
For investors, understanding inflation is an important part of financial planning. Even if your investments increase in value, they may not be growing quickly enough to maintain your purchasing power over time.
So, what does inflation mean for your investments, and what can you do to prepare for its effects?
What is inflation?
Inflation is the rate at which the prices of goods and services increase over time. When inflation rises, the same amount of money buys fewer things than it did previously.
For example, imagine you have £10,000 in savings. If prices rise by 3% over a year, goods and services that cost £10,000 at the beginning of the year would cost approximately £10,300 a year later. Your money has not disappeared, but its purchasing power has fallen.
Inflation is usually measured using an index that tracks changes in the prices of a representative basket of goods and services. In the UK, the Consumer Prices Index (CPI) is a key measure.
Inflation does not affect everyone equally. Your personal experience depends on what you spend money on, as well as how your income and savings change over time.
For investors, the important question is whether the returns on your money can keep pace with rising prices.
How does inflation affect investment returns?
One of the most important concepts to understand is the difference between nominal and real returns:
A nominal return is the percentage increase in the value of your investment before accounting for inflation.
A real return measures how much your purchasing power has changed after inflation is taken into account.
For example, if your investment grows by 6% over a year while inflation is 3%, your real return is approximately 3%.
If your investment grows by 2% while inflation is 4%, your real return is approximately minus 2%. Although the value of your investment has increased, it buys less than it did a year earlier.
These figures are illustrative and do not account for investment charges or tax, which can further affect the return you keep.
This distinction matters particularly when planning for retirement or other long-term goals. You need to consider not just how much money you may accumulate, but also what that money is likely to buy in the future.
How does inflation affect different types of investments?
Inflation can affect different investments in different ways. No asset class performs consistently well during every inflationary period, so it is important to understand the potential benefits and drawbacks of the investments you hold.
Cash savings
Cash is useful for emergency funds, short-term spending and money you cannot afford to expose to investment risk.
However, if the interest rate on your savings account is lower than inflation, the purchasing power of your money will gradually decline.
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