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Predicting the Effect of Inflation on Investment Decisions

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

Successful investment decisions are made carefully by financial advisers that understand the micro- and macro-economic factors at play. In this lesson you'll learn how one of those factors - inflation - can help investors anticipate market trends.

What Is Inflation?

Understanding how inflation may impact investment decisions actually isn't as complex as it may sound, as long as you have a solid understanding of both the goals of investors and the concept of inflation. So, let's start by explaining what inflation is and how it affects the economy.

The idea of inflation is based on the economic concept of the time value of money. That concept states that over time, money loses value. Said another way, over time, prices rise. Think about this for a minute - what does it really mean? Remember growing up and a parent or grandparent used to say 'When I was your age, I could walk down to the grocery store and buy a candy bar for a nickel,' and yet when you wanted to buy one it cost 50 cents, or maybe a dollar? Why did the same product, made the same way, cost a nickel 50 years ago but cost a dollar today? In fact, haven't production processes become more efficient over the last 50 years? Shouldn't things cost 'less'?

The answer, of course, is inflation. During the growth phase of the economic cycle, businesses grow, hire more workers, and pay more wages. That gives more people more money, and they spend it on things, including candy bars. Pretty soon, the candy bar seller can't keep up with demand, so how does she slow down demand? She raises prices. This makes the candy bar, or whatever good or service you want to use as an example, more expensive. Candy bars are obviously a simplified example but not necessarily inaccurate. Economic growth spurs spending and spending leads to price increases, also known as inflation.

How Does Inflation Impact Stock Investments?

Let's put a pin in the inflation talk for a minute and move to investments. Stock is a share of ownership in a company, and bonds are loans to companies. Well, isn't stock in a company essentially an economic good? After all, it has a price and can change hands, right? So, all else being equal (a very important assumption to make here), what happens to stock prices when inflation is high? Prices rise.

So, if inflation makes stock prices go up, does that mean that inflation leads to people investing in the stock market? Maybe, but maybe not. Stock market investors don't just want prices to go up; in fact, to make real money, they need the stock price to increase more than the rate of inflation. If not, they are essentially losing money.

Example

Let's run through a simple example that should clarify the idea of inflation and its impact on stock investments.

To keep the math easy, let's say a gallon of gas costs $2.50 today. And, to make life easy, let's say you just bought 1 share of ABC company for $10. So, 1 share of ABC stock is $10, which is comparatively equal to the cost of 4 gallons of gas ($2.50 per gallon times 4 gallons).

Over the course of the next year, inflation is out of control at 10%, so in one year, gas prices have increased to $2.75 a gallon ($2.50 + 10%, or .25). But, don't worry - your stock did well, too. It yielded the average market gain of about 7%, so your $10 is now $10.70. So, did you make money?

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