Inflation has gripped the world and is impacting both global markets and the real economy. Central banks are raising interest rates in a blunt force attempt to slow economies, suppress demand and drive down inflation at all costs. But while the economy is slowing, inflation is proving persistent.
The markets have responded with falling stock indexes and an enormous sell off in global bonds, the worst in decades. Some stocks are seeing crashes akin to those seen in the dot com bubble of 2001, with highflyers of 2020 crashing over 90%!
This year has seen the greatest destruction of wealth ever seen, with stocks such as Microsoft and Amazon shedding over 1 trillion in market cap value from their all-time highs.
Companies like Meta are one third the size they used to be. It’s not only the most speculative areas that have seen their bubble burst. Some of the most owned stocks in the world have seen an unprecedented loss of value.
There appears to be nowhere to hide, and with cash values being eroded by inflation, where should investors put their money?
In this article, we will explore how to invest with rampant inflation with 3 key tips that investors should adopt to limit volatility and attempt to drive positive returns in a challenging investment environment.
Practice risk management
Have a set of rules that protect your portfolio and never deviate from them. Generating returns is enormously harder if you have to claw back sizeable losses, but how do we go about doing this?
Firstly, limiting your exposure to a single stock name is key. No stock is safe in this environment. We already cited Amazon, Microsoft, and Meta as key examples of this.
What were once the stalwarts of the stock market that led the charge in the enormous returns over the past 10 years were reduced to penny-stock-like movements.
Take Amazon, despite beating on earnings, the stock fell 10% on the news. Earnings beats are rarely celebrated and those that miss are punished dearly. The stock is down over 55% from its all-time high.
A key way to practice risk management is to avoid trading on margin. Borrowing to invest in a highly volatile market, with more 1% swings up or down in a single year since the great financial crisis is a quick way to wipe out your entire portfolio.
While volatility can be your friend on the way up, it becomes an investor’s worst enemy on the way down, particularly if trading on margin.
The rise of single-stock ETFs with 2 or even 3 times leverage make it easier than ever to be tempted into them. After all, if you are certain that you’re catching the bottom of a falling knife, why not make 3 times as much on the way up?
Unfortunately, it’s not that simple, and many investors get caught up in risky instruments that they don’t fully understand, only to have their entire account wiped out.
Risk management is key to success in the long run. Always practice it and never deviate from your rules. If you’re unsure of what rules to set yourself, there are some excellent principles that you can practice by the likes of Ray Dalio, Warren Buffet, and other great investors on great ways to manage risk when investing in the stock market.
We talked about volatility being at the highest levels this year since the great financial crisis, which bring us on to our second tip on how to invest with rampant inflation. Limit the volatility in your own portfolio by investing in dividend stocks.
Dividend stock investing
While the market as a whole may be volatile, our investments don’t need to be. Companies that pay a strong and reliable dividend effectively set a floor on their stock price. Eventually, the price of a quality dividend stock will fall to a point where income investors simply cannot ignore it.
Take Johnson & Johnson for example. If the stock fell to a price where it was yielding 6%, investors would be piling in hand over fist, gorging on the stock to secure a high, yet extremely consistent dividend growth stock.
Compare that to a company like AMD that does not pay a dividend. If the stock fell 50%, it could simply be down due to multiple compression, and with no dividend to attract potential buyers, there is less reason to invest in a company seeing a sharp loss in its share price.
If a growth stock erases all of its gains over several years in a single bear market, investors can be left with no real return, and possibly even a negative return. With dividends, that is less likely to be the case.
Dollar cost average into low-cost ETFs
The third and final tip for investing in a market environment with high inflation is to dollar cost average into diversified, low-cost index funds. Spreading your investment evenly over a long period of time eliminates exposure to any single event.
Over time, if stocks fall due to persistent inflation, you can simply invest again at lower prices, and your average cost will decrease. Conversely, if you dollar cost average into a rising market, you maintain a positive return while increasing your average cost.
A hot take that some investors have is not to buy low and sell high, but rather to buy high and sell higher, essentially meaning that buying stocks in a rising market environment with a positive backdrop leads to higher prices in the future.
Investing in a bear market like we are in now could very well lead to lower prices in the future, much like we have seen in recent history, but once a downtrend is broken, history has shown that the market erases all of its losses and returns to all-time highs.
As investors, we need to stay in the market to benefit from these moves, and dollar cost averaging is an easy rules-based method to follow when investing.
Over an investing lifetime, there are times where you will overpay for stocks and there are times that you will underpay for them. Consistently investing each week, month or quarter will allow you to neutralise any shocks that the market endures and allow you to build a portfolio for the long term.
As a long-term investor, you should want lower prices today for better returns in the future. Wealth is not built overnight in the stock market, and requires both patience and discipline.
