Inflation is the one dreaded word that can shake the confidence of economists, investment bankers, and even the government!

Well, the harsh reality is that if the economy is growing, inflation will definitely raise its head to haunt you. Let’s try to explore why it is such a dreaded word and is there any hidden opportunity for an investor to generate profit out of this?

Inflation is a state where there is steady increase in price of goods and services. If there is too much money rolling in the system, it will lead to inflation as people will have more money, which makes them willing to pay more for the same amount of goods or services.

Effects on markets

The best buddies of inflation are rising interest rate, crashing stock markets, unemployment, rising bond yield and of course stress, which makes it appear on everybody’s watch list.

Market behaviour: Inflation numbers are closely watched by analysts and investors. If there is slow and steady growth in inflation stock market behaves positively as inflation is considered a necessary evil. If the number is too high then we always see a knee jerk reaction in the negative direction.

Interest rate cycle: The prime reason for inflation is too much money in the system. Hence to curb it, policy makers increase interest rates, so that liquidity is sucked out of the system. But as the interest rate rises, so does the cost of capital. Increasing cost of capital hampers the earning potential of companies, leading to decreasing confidence of investors, resulting in stock market fall.

Once the stock market falls people start running towards safer options like investment in government securities. At this point, excess money se-ems to be resting in peace and the interest rate starts to decline and the whole cycle starts again!

Effects on investment decisions

So should you alter your investment decisions based on it? If your investment is in fixed income securities or in bank deposits, then the answer is yes. Returns from fixed income securities are quite closer to inflation rates and hence you do not gain much in long run.

The situation is worse, if you sit on pure cash as your purchasing power is dwindling day by day. If we cannot avoid inflation, let’s figure out how to extract the most out of it.

Investment in stock market: Generally, every good company in the long run generates earnings, which is above inflation rate. As a smart investor, one should look for firms, which can utilise this pricing power in times of persistent inflation.

Commodity prices are quite reactive to inflation and adjustments in prices are very fast, so one should not ignore companies which deal in commodities.

Investment in real estate: Investment in home and land is always a safer option. Generally the price of a house and land increases with time and rate of appreciation is higher, as land is a limited resource.

Inflation indexed bonds: RBI is exploring the possibility to bring out inflation-indexed bon-ds. The return on these bonds will be a little abo-ve the rate of inflation.

As it’s clear that we cannot avoid inflation let’s make some smart investment choices to cope with it better. Inflation at times provides you an opportunity to buy some good stocks at cheaper prices. Just remember to be vigilant and look out for opportunities.

(The writer is the CEO of bankbazaar.com)