Inflation and investing to beat it

The value of your investments and the income you receive from them can go up and down, and you may get back less than you invest. Any examples are for illustration purposes only.

Without checking, how much does a Freddo cost? If you said 5p you probably remember picking one up pre-1990s. 10p? Dust off the Groovy Chick jeans, you’re core 90s. In actual fact, you’ll have to part with 30p to nab a chocolate frog now - a hike so horrifying to one Labour MP he set up a petition to bring the 5p bar back.

As painful as it all is, it’s a useful case study to demonstrate the rate at which prices increase over time i.e. inflation. It’s a broad measure as different and ever-changing factors influence the price of all goods and services in a range of ways. The important part to remember is inflation is a measure of the rate of change in these prices over time, normally a year.

Staying in Freddo-land, if your earnings stay the same year to year but the things you want to buy get slightly more expensive, your pay naturally won’t go as far each month. The same amount is still dropping into your bank account but its purchasing power is slowly eroding. It’s weird to think you could be worse off even though nothing has changed in terms of your income but it’s true. It’s this effect savers and investors are keen to overcome.

So, that’s how inflation can become a bit of a silent spending killer but what causes it? A whole lot of things. Here are a few of the most common influences:

When the price of basic and raw materials rises, those extra costs often get passed on to the end consumer in the form of higher product prices. This is called cost-push inflation. Case in point, cocoa prices spiked in 2024 after a drought devastated crops in West Africa. This eventually fed through to the chocolate bars on supermarket shelves.

When demand for a product rises quicker than suppliers can make it, and prices rise as a result, the effect is called demand-pull inflation.

An increase in wages, brought about by a rise in the minimum wage, for example, could lead a business to raise the price of its goods to cover the extra staffing costs. In this case, wage-push inflation is in effect.

The government’s fiscal policy can influence inflation too; for example, if it were to stimulate spending by reducing taxes. Higher overall demand can lead to price rises here.

Central banks’ use of monetary policy can have a similar influence. After the financial crash in 2008, interest rates around the world were nailed to the floor in a bid to make spending more attractive than saving in a low-inflation environment. Then, as inflation climbed after Covid, central banks raised interest rates in an effort to tame spending and bring inflation down.

Source: ONS, Bank of England, as at 19 February 2025.

As with most influences in markets, it’s rare to see only one force in play at any one time. That makes it tricky to figure out exactly which is having the greatest impact and which is sparking off which so tackling inflation can feel like a bit of a balancing act.

Just as inflation eats away at the cash in your pocket, it goes after your cash savings too. If the interest rate you are getting on your savings account is lower than the current rate of inflation, even though you’re earning interest it still won’t keep up with broader price rises. You’ll get slightly richer but the price of the things you want to buy will outstrip your new riches.

It makes the prospect of hoarding cash unattractive for a lot of people who are willing to accept the risk of the stock market in an effort to aim for above-inflation returns.

As we’ve mentioned, any return on an asset that doesn’t at least match the rate of inflation is slowly chipping away at your pricing power. It stands to reason that we’d hop into assets that we think will outperform inflation then, right? Most likely, yes, but we do have to acknowledge, when we move from cash savings into assets like stocks or bonds, that we put our foot on the first rung of the risk ladder.

These assets can go down as well as up and, whereas it’s fairly certain your cash will always be there to draw upon, with investing, you can end up with less than you put in. This doesn’t mean it’s a coin toss - with good research it’s far from it - but seeking inflation-beating returns through investing does require us to rise up the risk scale.

Of course, you could say sitting in cash offers a risk of its own - that of losing spending power - and it even has its own name. Inflation risk, naturally.

This is where the long-term performance of stock markets helps offer a perspective on the efficacy of investing to fight inflation. Whereas the US and UK try to keep inflation to 2%, the long-term average annual return for the S&P 500 Index (since 1957) is around 10% with the FTSE 100 delivering a total return of around 8% per year, from its inception in 1984 to 2024.

Having a look at even just the past five years shows this wasn’t all smooth sailing and investors have to be ready for periods of underperformance. Still, the long-term figures demonstrate how stock market indices have the capacity to beat inflation and keep your purchasing power alive.

Discrete calendar year performance

As at 19 February 2025. Source: FE Fundinfo. Past performance is not a reliable guide to future gains or indicative of future performance.

We would all like a surefire inflation-proofing strategy but, while there’s no perfect way to protect your portfolio against its effects and keep your stocks growing during bouts of price rises, there are some sensible tenets to keep in mind:

• If you need cash to meet short-term expenses, that’s not a bad reason to avoid the risk of the stock market but it might not be best to hang on to it for a long time in your investment portfolio. The danger is we leave cash sitting in our investment accounts for so long while we deliberate our next move that it falls victim to inflation in the meantime.
• If inflation rises and central banks raise interest rates in an effort to tame it, that could mean companies find themselves starting to pay higher interest on any money they’ve borrowed. Keep an eye on how much debt the companies in your portfolio have - if a hike in rates would stop money being put to use in growing the business, it’s not a great sign.
• Firms able to absorb higher costs without a meaningful hit to margins are highly prized during bouts of inflation. As are those with brands strong enough to pass higher costs onto the consumer and still maintain customer loyalty. We often call this ability ‘pricing power’ but be careful - consumers might not always be able to go for the brand name if inflation really starts to bite. In that case, trading down to the supermarket value alternative can get more and more attractive.
• A popular train of thought is to invest in the raw materials themselves i.e. commodities, as the source of inflation often leads back to hikes at the very start of the supply chain, as in our coca example. Not all commodities were born equal though, and can respond to inflation in different ways. For example, investors tend to treat gold as a kind of ‘safe haven’ in times of uncertainty - it’s not a perfect solution and commonly only serves to protect against particularly high inflation or when worries grow over the ability of central banks to implement policy.

Sources:

• BBC
• ONS
• Bank of England
• FE Fundinfo
• Investopedia
• MAFS Ltd

Important information

When you invest your capital is at risk. Past performance is not a reliable guide to future gains. Your investments and the income you receive from them may go down as well as up so you may get back less than you invest.

Make sure to do your own research on what investments are right for you before investing or consider seeking expert financial advice. Please note that this article is meant for information and does not constitute any financial advice.

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