One of the most disturbing statements released by the World Economic Forum earlier this year is that the UK will be the only G7 country to experience a recession. One reason for this is the immense spike in the country’s inflation rate experienced last October 2022 to 11.1%.
Even though things are starting to improve, the effects of this inflation hike (the first in over 40 years), everyone is still feeling the results. That includes investors.
Inflation is arguably one of the most—if not, the most—significant risks investors in the UK are currently facing in today’s economy.
That’s because inflation has this uncanny ability to reduce your investments to nothing.
In this article, we’ll explore the impact of inflation on UK investments, why managing this risk is essential, and how to do it.
Understanding Inflation Risk
Inflation risk is the possibility that the inflation rate will outpace the rate of return on an investment, leading to a decrease in the purchasing power of the investment’s returns.
For example, let’s say you invest £10,000 in a portfolio of stocks and earn a 5% return in a year. If the inflation rate for that year is 3%, the real return on your investment is only 2%.
Inflation reduces the value of your money, which means that you’ll need more money in the future to purchase the same amount of goods and services. As a result, inflation reduces the purchasing power of your investment returns and can hurt your ROI.
This can be potentially problematic because inflation erodes the value of your investments over time, potentially leading to a loss of the wealth you’ve worked so hard to gain.
COVID-19 and Inflation
The outbreak of COVID-19 has also contributed to inflation in the UK. The pandemic led to supply chain disruptions, shortages of critical goods and services, and a shift in consumer behaviour, all of which significantly impacted inflation.
One way COVID-19 has contributed to inflation in the UK is through supply chain disruptions. Lockdowns and other restrictions have led to factory shutdowns and decreased production capacity, causing crucial inputs and materials shortages. This has resulted in higher production costs for businesses, which they pass on to consumers by increasing prices.
Investment Risk Management Tips During an Inflation
Diversify Your Investment Portfolio
Diversification can help reduce the risk of loss in one asset class by spreading your investments across others that are less correlated. This can help protect your investments against inflation and other market risks.
Allocate a part of your investment portfolio to inflation-linked gilts (also called inflation-indexed bonds). These are securities whose value is linked to inflation rates, meaning that they may provide a hedge against inflation.
Commodities, such as precious metals or agricultural products, may also help protect against inflation as their prices tend to rise during periods of inflationary pressures.
In addition, you may want to consider investing in startups with pricing power, which refers to a company’s ability to increase prices to offset the impact of inflation on costs.
However, it’s important to remember that investing in early-stage startups in the UK comes with its own risks, so it’s essential to do your due diligence and consider the potential risks and rewards before making any investment decisions.
Regularly Monitor Critical Economic Indicators
Keeping your finger on the pulse of specific economic indicators such as interest rates, gross domestic product (GDP), and unemployment rates can also provide valuable insights into the economy’s health and potential risks to your investments.
One indicator to watch closely is Consumer Price Inflation or CPI. This measure of inflation tracks the prices of goods and services. By monitoring the CPI, you can understand how prices are changing in the economy and make informed decisions about your investment portfolio.
Another way to stay informed about inflation trends and economic indicators is to read financial news and analysis from reputable sources. Many provide in-depth coverage of economic trends and analysis of how these trends may affect investments.
Additionally, subscribing to newsletters or podcasts from investment experts can provide valuable insights and analysis on market trends and investment opportunities.
By monitoring these indicators, you can make informed investment decisions that align with your risk tolerance and financial goals.
Hedging is a risk management strategy that successful investors use to reduce or offset the risk of loss from adverse price movements in their investments. It involves taking a position in an asset negatively correlated with another within your portfolio. By doing so, you are essentially reducing your exposure to a particular risk, such as inflation.
For example, if you hold a portfolio of stocks and are concerned about inflation eroding their value, you may choose to invest in inflation-protected bonds, which typically perform well during inflationary periods. This would help offset any losses you may experience from the stocks in your portfolio.
Another hedging strategy that you can use to mitigate inflation risk is investing in alternative assets that are not directly affected by inflation. These can include real estate, precious metals, and early-stage startups.
Real estate is often considered a good hedge against inflation since property values and rental income can rise along with inflation. Precious metals such as gold and silver can also serve as a hedge, as their value tends to increase during inflation.
These assets remain resilient during inflationary periods as their prices are often linked to inflation. For example, when inflation rises, the value of real estate tends to rise along with it, as property values and rents increase to keep up with rising costs.
Similarly, precious metals like gold and silver have historically been seen as a haven during times of inflation, as their value tends to increase when other assets decline in value.
Consider Investing in Early-Stage Startups
Investing in EIS and SEIS-certified startups can offer tax benefits and potential returns. These schemes incentivise investment in small businesses and startups and can provide tax relief for investors. Investing in startups can also provide an opportunity for higher returns than traditional investments.
In addition to the potential returns, investing in EIS and SEIS-certified startups can provide a hedge against inflation. Startups tend to be less affected by inflation as they have more room for growth, which can offset the impact of inflation on their expenses. Also, investing in startups is typically a long-term commitment, which can provide a buffer against short-term market fluctuations caused by inflation.
Although investing in startups comes with risks, investing in EIS and SEIS-certified startups can diversify your risk across multiple investments and potentially benefit from inflationary trends.
Working with a consultant specialising in early-stage startup investments can provide valuable insights into the risks and benefits of investing in startups in different stages of growth, help you make informed decisions, and provide ongoing support to keep you on track with your investment plan.
Managing inflation risk is crucial for UK investors looking to protect their investments in a volatile market. By diversifying your investments, monitoring economic indicators, and using hedging strategies, you can help mitigate the impact of inflation on your portfolio.
One of the most effective strategies for managing inflation risk is investing in startups certified by EIS and SEIS. These schemes offer potential tax benefits and higher returns, and startups can also hedge against inflation and market fluctuations.
It’s important to remember that investing in startups comes with risks, and it’s crucial to seek professional advice and diversify your investments to manage these risks effectively. You can maximise your investment returns while managing inflation risk by staying disciplined, periodically rebalancing your portfolio, and working with a financial advisor.
In a volatile market, protecting your investments is more important than ever. Considering the potential benefits of investing in EIS and SEIS-certified startups, it’s worth exploring this option as part of your investment strategy.