How higher inflation relates to diversification

The importance of diversifying your portfolio cannot be emphasised enough. Diversification is a risk management strategy in which you invest in a variety of different financial assets, and which, in the event of significant market volatility, may reduce your chances of incurring major losses. The importance of diversification can be illustrated in the high inflation period happening before our very eyes.

Commodities market is going crazy

There are significant developments in the market this year which are not receiving their due attention. It is not because their importance and implications are not understood, rather, that they are being overshadowed by other events. All attention had been focused on the surge of cryptocurrencies — from Bitcoin to Dogecoin — until late May, and then on their subsequent plummet. However, the commodities market has soared in 2021, and if not for cryptocurrencies, this would be a central focus of the markets.

In the chart below, you can see the surge in futures contracts since the middle of 2020. The price surge in these contracts causes consumer goods to rise in price, resulting in inflation.

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Semiconductor scarcity generates inflation

The semiconductor industry is another field generating inflation.

Currently, there is a chip shortage in the world which may have significant ramifications for the global economy. For example, although semiconductors make up only 0.3% of the US GDP, the products that use them make up 12%. Chips are indeed the brain of every electronic device.

The chip shortage began at the outset of the pandemic when automakers were purchasing less chips, believing that lockdowns would reduce auto sales. Simultaneously, consumer purchases of products using chips surged. Auto sales picked up faster than expected, creating a situation where both industries were competing for chips from semiconductor manufacturers, while production of the chips remained steady.

This intense competition for chips has caused prices to rise across the board, or in other words, inflation, and estimates are that the chip shortage will not be resolved any time soon.

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Inflation erodes the real profit of tech companies

Over the past year, the US Federal Government has spent more than $5 trillion dollars on Covid-19 relief legislation. These relief packages are in addition to the regular Federal government budget, and are increasing the federal debt significantly. While the Fed can continue to print money nonstop, the effects are being felt in the bond market.

But high inflation actually hurts tech companies. The reason is because the valuation of high growth entities such as tech companies is based on a forecast of a percentage of increase in cash flow per year. However, high inflation erodes the real profits over the long term. Even more, the uncertainty of interest rates make it more difficult to value the company at present.

Different financial assets are competing with each other for investors’ money. As interest rates go up, investing in bonds can be suddenly more attractive than investing in stocks. This is because the way to reduce inflation over the long term is by raising interest rates. Bonds which work on interest rates, therefore, may become a more attractive investment at some point.

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Financial companies prosper during inflation periods

Portfolio diversification is something that cannot be stressed enough. Diversification may reduce investors’ risk exposure by ensuring that investments are spread out over various asset classes. A rising rate of inflation offers investors opportunities to hedge their investments by investing in financial assets that prosper during periods of inflation. For example, banks provide loans and collect interest on those loans. Inflation causes higher interest rates, and, thus, banks generate higher profits from their loans. However, rising inflation underscores one of the most important lessons of investing, which is to diversify your portfolio.

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