The Reserve Bank of Australia (RBA) defines inflation as: “an increase in the level of prices of the goods and services that households typically buy.” 

Simply put, something that cost you $5 last year will, due to 8% per cent annual inflation for example, cost you $5.40 today. 

I am sure you are seeing some of this when you do your weekly grocery shopping. The rising cost of the products (i.e., inflation) that fill your shopping trolley means you have to pay more for what you usually consume. This leaves less money to be enjoyed on other things.

Uncontrolled, severe inflation can lead to social unrest and other problems, like having to use wheelbarrows as a wallet to cart your money around! (Google: “wheelbarrow inflation” to get a sense of how bad things can become!)

To counter this inflation, reserve banks usually lift interest rates to curb spending and reduce the amount of money sloshing around an economy. So, it’s not surprising that the term “inflation” spiked in Google Trends as the RBA first started raising interest rates back in April 2022.

If you earn 4% interest from your bank and the inflation rate is 7%, then the real rate of return on your money is -3%. That’s before factoring in taxes you might need to pay on the interest earned. This means that after tax you’re likely to have even less.

In a high inflation environment, you could potentially be going backwards by leaving most of your savings in cash and term deposits, as the prices of goods and services are rising faster than the prevailing interest rates.

Inflation, though, doesn’t have to be all doom and gloom. In fact, you can invest in a way that potentially helps you generate passive income and also protect your portfolio from inflation. 

To achieve this, here are three things that Stockspot suggests to its clients.

Tip 1: Stick with low costs and simplicity

[Editor’s note: Like all investment products, actively managed funds have pros and cons. The choice between active funds and passive funds (most ETFs) is not always binary. Different types of fund investment styles can play different roles in portfolios. Some active managers have delivered strong long-term returns for their clients, just as some managers have underperformed their benchmark index, after fees. The key is to choose the right investment style for your needs, on your own or in conjunction with a licensed financial adviser].

There’s a reason why less than 15% of active Australian share funds, according to the S&P Dow Jones research, have beaten the market over the last decade. It’s because the fees investors pay are a killer - much like termites eating away at your home, fees eat away at your money day after day.

While some active fund managers do have skill, the S&P research shows that over the long term, many active fund managers underperform the market.

Studies consistently show that low-cost index funds that track the broad market and passive ETFs tend to outperform their higher-cost, actively managed counterparts over the long-term.

This outperformance is largely due to lower fees, allowing more of your investment capital to work for you in the market. 

As an example, an investment product that charges you 0.3% compared to one charging you 1.3% means that on $100,000 invested over a 25-year period, a gross return of 8% ends up at $681,312 compared to $531,398. That’s a difference of $150,000.
 

Tip 2: Don’t chase high yields blindly

There’s a popular saying: if it’s too good to be true, it probably is. The same applies to the dividends (or yields) on shares.

As a kid, I remember visiting the ASX auditorium every Wednesday afternoon to learn more about investing. I would be mesmerised by the free educational talks offered and the bright ticker boards showing share price movements. I would then go home and research which companies on the ASX had the highest yields/dividends.

What I didn’t know at the time was that high-yield investments come with higher risk. Typically, investments offering high yields (say, of over 8%) can potentially be either risky or are complex structured products. 

With some funds, the dividend yield is a mirage - you are just robbing Peter (capital) to pay Paul (dividends).

Now, you may get lucky and get away with picking a high-dividend stock and being able to get your capital back. However, like picking up pennies in front of a steam roller, eventually the risk of this approach will be exposed because there’s no free lunch. Rather than focusing solely on income, consider the total return of an investment as your benchmark of performance.

Also keep in mind, if you’re investing in a taxable account (i.e. you’re not in the super pension stage), that higher-yield investments often face higher taxes because income can be taxed more heavily than long-term capital gains. 

Assess your tax situation and risk tolerance when planning your investment strategy. For many people, it may be more tax efficient to sell down some capital rather than get income. 
 

Tip 3: Include some inflation protection

As inflation and interest rates rise, high-dividend-paying shares and bonds with high yields can become relatively less attractive at the same time, potentially leading to price declines. 

To offset this risk, consider including inflation-protected assets in your portfolio like commodities, inflation-protected bonds and resource shares.

In a study by Cambridge Associates, commodity futures and gold topped the list of assets most sensitive to inflation. A 1% increase in the inflation rate over one year was estimated to increase gold performance by around 9.4%.

These assets were followed by resource shares and inflation-linked bonds. Assets that have historically done less well with rising inflation were traditional bonds and shares. 

The great thing is that these days all investors (from retail to sophisticated institutional players) can easily buy and sell gold, commodity futures, resource shares and inflation bonds on the ASX. Exchange traded funds (ETFs) have made this possible and lowered the previously steep barriers to entry for all investors.

By incorporating these assets into your portfolio, you can potentially reduce the negative impact of rising inflation and interest rates on your returns.

In my experience, the best way to keep up with inflation when investing is by keeping your portfolio costs low, diversifying broadly, owning some inflation-protected assets and focusing on total returns rather than dividend yields alone.

Risks with investing for inflation-protection

Be aware that some of these assets, like resources and shares, have a decent yield whereas others, like gold, don’t.

Generally, inflation assets don’t have high yields so this is the compromise you need to make to reduce the risk of having your portfolio gobbled up by rising inflation and interest rates.

DISCLAIMER

Stockspot Pty Ltd ABN 87 163 214 319 is a licensed Australian Financial Services provider (AFSL 536082) regulated by ASIC. Any advice contained in this article is general advice only and has been prepared without considering your objectives, financial situation or needs. Before making any investment decision we recommend that you consider whether it is appropriate for your situation and seek appropriate taxation and legal advice. Investing into financial products involves risk. Past performance of financial products are no assurance of future performance. Please read our Financial Services Guide on stockspot.com.au before deciding whether to obtain financial services from us.