Questions About Finance
by Taylor J. Kovar, CEO – Kovar Capital
–Hey Taylor – How does inflation affect the stock market? I’ve always wondered about that and get hesitant to buy stocks because I don’t know if interest rates are about to go up and whether or not that should change my tactic. – Olan
–Hey Olan – This one is a doozy. I’ve read a lot of studies relating to inflation and the stock market, and I’ve heard so many different theories as to whether inflation is good or bad for investors. I guess the short answer to your question is that there is no short answer. However, here are some notable factors that can at least shed a little light on the issue.
1. Inflation tends to hurt growth stocks more. Since inflation drives down the value of the dollar, it typically hurts growing companies a little more than established businesses. If you own stock in a small tech company that needs to spend money in order to grow, a weakened dollar isn’t going to help you out. Meanwhile, when you own value stocks that are slowly ticking up in price, inflation can actually help you out in some cases. In theory, owning stocks in the long term is a safeguard against inflation, since you can expect a good company’s revenue to go up along with the inflation rate.
2. There is a sweet spot. Inflation studies, of which there are plenty, show that the best real returns come when inflation is sitting between 2-3 percent. This doesn’t mean you should buy in excess when inflation is holding steady, but rather you should avoid panicking when it goes up or down a little bit. It always takes a bit for the economy to adjust and get back on track after a period of high inflation. This also usually leads to more volatility in the stock market, so it might be worth waiting to see if the Fed makes a move and then watching the market’s reaction.
3. Play it safe when inflation is high. While you might see someone hit it rich during a time of high inflation, returns are historically lower during those periods. I don’t think you need to avoid the stock market when the rates go up, but it’s probably not the right time to go hog-wild. Look at trends and keep an eye out for stocks that seem undervalued, but don’t start overcorrecting and making too many moves when there’s increased inflation.
This is a solid question, Olan, and I’m glad you’re being this thoughtful with your investing. One of the smartest things an investor can do is research what the market has done historically. When you have an understanding of the causes and effects related to past inflation, that will help with the decisions you make in the future.
