Inflation: what, how and why?

Inflation occurs when there is an overall and continual rise in the price of goods and services over a given period of time. In other words, money loses its value. Over time, you buy fewer products with the same amount of money.

Many factors can influence inflation. The main ones are the following:

Inflation may be due to an increase in production costs. Cost-push inflation generally kicks in when there is a rise in the price of imported raw materials and finished products, wage costs, or an energy crisis that generates shortages.

It can be demand-pull inflation. This form of inflation is caused by an imbalance between supply and demand for one or more products. Demand exceeds supply; prices rise mechanically until an equilibrium point is reached and inflation is created.

Inflation can be monetary. There is an excessive increase in the quantity of money. Too much money circulates in comparison to the goods and services available in the market.

Lastly, inflation can be caused by a lack of confidence in the currency. If the currency no longer inspires confidence, this is reflected in the financial markets by a fall in its exchange rate. As a result, the prices of imported goods increase by the same proportion.

Inflation is never good news for your wallet. It may affect your purchasing power, even if Luxembourg has set up an automatic index-linking of earnings to the cost of living. The indexation consists of studying the evolution of the prices of a sample of goods and services representative of household consumption (approximately 8,000 goods and services collected into 255 categories) and periodically adjusting wages according to these changes. When the average consumer price index rises or falls by 2.5% in the previous six months, earnings are in principle adjusted by the same proportion.  

Your savings may also suffer a reduction in purchasing power in the event of inflation. If its return is lower than the inflation rate, its capital is gradually eroded. The amount remains the same, but not its actual value.

Risk diversification: the magic of eggs in multiple baskets!

So, what should you do to protect yourself from the negative effects of inflation? Don't put all your eggs in one basket. If, for example, you have only invested in savings products, it might be time to diversify into more dynamic assets that are more resistant to the corrosive effects of inflation. Every asset, whatever it is, has the probability of having a negative return, but the risk is not the same for all assets, as it depends on several factors. To limit the natural risks of investing and maintain profitability with less exposure, the best strategy is to compose your portfolio with different types of assets. Doing this prevents you from investing everything in a single security and losing all or part of your investment if the situation becomes unfavourable. If one of your options falls, it will be compensated by your other investments.  

There are three main ways to diversify your portfolio: across sectors, assets and markets. For example, all sectors of activity have their characteristics and do not experience cycles or crises in the same way. Diversifying according to this criterion will help to overcome any damage affecting a given sector. Similarly, the returns of different asset classes, such as equities, bonds and cash, never - or very rarely - go up or down simultaneously. When one asset class has average or low returns, another will perform well. Gains in the other will offset losses in one. Another smart alternative is to expose your investments to several geographical areas. Even though the economy tends to become more global, each country's economy keeps its characteristics. You can also combine all three types of diversification.

While diversifying a portfolio may seem relatively easy if you are interested in the stock market, it is much less so in reality. There are so many financial products on offer that it is challenging to create a balanced portfolio of assets if you do not have a good knowledge of the markets and do not have enough time to devote to it. It will also depend on your risk aversion. So, don’t hesitate to talk with your banker before starting to invest.

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