How traders can diversify their portfolios during periods of inflation

By Kate Leaman, chief market analyst at AvaTrade

In the wake of the pandemic and the ongoing Russo-Ukrainian war, inflation rates have continued to increase in the European Union, United States, and many other regions. In fact, the war has further exacerbated already high consumer prices caused by the COVID-19 pandemic and disrupted supply chains, leaving central banks with no choice but to further increase interest rates to tame price hikes.

This surge in global inflation has sent ripples throughout the financial landscape, leaving traders and consumers alike suffering the consequences. Nonetheless, as prices soar and monetary value weakens, it is increasingly important for traders to adopt a proactive approach that safeguards their investment portfolios.

Inflation jeopardising portfolios

Rising inflation rates can have significant implications for traders as well as their portfolios. In an inflationary environment, the value of money diminishes, leaving the purchasing power of cash to decline over time. As a result, the returns on investments (ROI) may not keep pace with the rising cost of goods and services. This can lead to a decrease in the real rate of ROI, effectively eroding the value of a trader’s portfolio.

With this in mind, it is essential that traders avoid making investments in specific asset classes that may be more vulnerable to the impact of inflation. For example, fixed-income securities, such as bonds, typically suffer from diminishing real returns during periods of inflation. Long-term bonds are even more susceptible to inflation risk due to their longer duration periods. When inflation rises, long-term bond prices are more sensitive to interest rate changes, leading to losses for investors.

As such, when responding to inflation, it is crucial for traders to adjust their investment strategies by diversifying their portfolios.

Protecting your portfolio

During periods of inflation, traders can implement various strategies to protect their portfolios by making high-quality investments that are resilient to rising prices. One effective approach is to diversify their holdings across different asset classes known to perform well in inflationary environments. Equities can play a vital role in helping to protect a portfolio, particularly stocks of organisations with robust pricing power and the ability to pass on increased costs to consumers. These organisations can adjust their prices to keep up with rising expenses, ensuring their profit margins remain healthy.

Additionally, investing in real estate is another worthwhile strategy when it comes to hedging against inflation. Real estate can see its value appreciate in line with inflation, and rental income can also offer a steady cash flow. Irrespective of the economic climate, there will always be a need for homes, making this asset a safe investment.

What’s more, investing in commodities is another useful strategy to beat inflation. For instance, the value of gold and silver tends to increase when the purchasing power of currencies such as the US dollar and Euro decline. The pair are often perceived as a store of value with intrinsic worth, serving as a hedge against inflation’s erosion of currency value.

These precious metals offer diversification benefits to a trader’s portfolio. In a scenario in which traditional assets like stocks and bonds are underperforming due to inflation, gold and silver often move in the opposite direction, helping to balance the overall risk in a portfolio.

Strategically diversifying

While a number of assets and commodities are capable of withstanding inflation, there is still a certain amount of risk. In terms of real estate, as inflation increases the prices of goods and services, construction costs often rise too, impacting a property’s value and the expenses associated with property maintenance. Similarly, prices of precious metals can be highly volatile, influenced by various factors like economic conditions and even geopolitical events.

As such, traders should make various inflation-resistant investments to protect their portfolios during inflationary periods. Strategically diversifying helps mitigate the risks associated with any single asset class. By holding a mix of assets that tend to perform well during periods of inflation, such as equities and real assets, traders can better safeguard their portfolios and maintain their purchasing power as the value of money declines.

A way through inflation

Diversification is key in creating a resilient portfolio. A mixture of stocks, bonds, real estate and inflation-protected assets can help mitigate the risks associated with inflation. When inflation strikes, the overarching goal for traders should be to construct a portfolio capable of withstanding its erosive effects.

Traders should focus on quality investments with strong fundamentals that have the capacity to adapt to evolving economic conditions. Staying informed about market trends, especially inflation rates, is imperative for making informed decisions and adjusting investment portfolios as a means of protection against the challenges posed by inflation.