Winning long term
Having a more meaningful understanding of why inflation is important and how it impacts on our ability to create wealth is a key element in creating a successful investment strategy. It may help us avoid making some of the more common mistakes that scupper our plans to achieve our long term goals.
So what do we really mean by inflation?
Technically speaking, inflation is an economic variable which measures the general increase in price levels of a specified basket of goods and services within an economy over time – usually stated as a year-on-year change.
I probably lost 50% of readership with that last sentence so in more simple terms, the inflation rate should give us an indication of how our general cost of living is changing from one year to the next.
As each individual consumes goods (food and clothes) and services (education and medical care) in different quantities, at different times of their lives, we all probably have a unique ‘inflation rate’.
But to simplify things we frequently talk about a broad inflation measure called the CPI or Consumer Price Index – this measure is calculated and published monthly by Statistics South Africa.
The South African Reserve Bank (SARB) tries to keep inflation between 3% and 6%. The most recent inflation release measured by the Consumer Price Index (CPI) was around 6.3%, or a little above this target, mostly as a result of rising fuel costs. As can be seen below, the inflation rate is not static but fluctuates over time as prices change.
What is a reasonable assumption for expected inflation?
We frequently use 6% as the rate of inflation in financial planning models as it is the top of the SARB target range and has been close to the historic average in recent years, as measured by CPI.
But is a 6% rate of inflation a fair representation of the actual level of price increases?
I took a report from Statistics South Africa which showed the price of goods in 1995 and compared them to a local supermarket’s online shopping site as of this week, the results of which are tabulated below:
What becomes glaringly obvious from this data is that our actual rate of inflation is probably much higher than the 6% average rate as measured by CPI. If you monitor the cost your medical aid premiums or children’s annual school fees you will no doubt have noted that these increase by on average 8.5% or 9% per year – again well above the inflation rate as indicated by CPI.
Why is the inflation rate important?
As with other aspects in investment planning, like fees and investment returns, the impact of a few percentage points here or there in any one year does not seem like a lot but when compounded over long periods of time the impact is frankly quite terrifying.
It is important to take note of inflation because it has the effect of reducing the ‘Purchasing Power’ of each individual unit of a currency (Rand) over time.
Consider this: The five rand note in South Africa was replaced by a coin in 1994.
If we took that five rand coin and put it under the mattress for safe keeping in 1994 and brought it out today what would it be worth? Would it still buy the same amount of a good as it did in 1994? Has it maintained its ‘Purchasing Power’?
If inflation averaged 6% over the 19 years then the real value of that five rand in today’s terms would in fact be R1.65. That is a fall in the ‘purchasing power’ of our five rand coin by two-thirds or 67%. In other words you could buy only 33% of the same good with the same five rand as you could in 1994….
To put this into terms we may easier understand – if a loaf of bread cost R3.50 in 1994, and the increased cost/inflation on bread was 6.0% per year, then that same loaf of bread today will cost us R10.49. In other words our R5 used to buy us almost 1.5 loaves of bread but now it will only buy us 0.5 loaves of bread – again we can see that our ‘purchasing power’ has fallen by two thirds.
Even more terrifying is that if inflation over that 19 year period averaged closer to the 9% (as evidenced in table 1 above) then that same five rand in today’s terms would only be worth R0.97, which represents a reduction in purchasing power of 81%. You could buy less than 20% of the same good with five rand than you did in 1994.
The implications of this must be understood – if you are saving for retirement in 20 years time and are using a 6% inflation rate to determine the target value that is required to provide an income at retirement, but the actual inflation rate is 9%, then you can do everything right and still land up with a shortfall of 43% in terms of your ability to cover your living expenses. Make no mistake, underestimating inflation is perilous to your financial well being.
How does inflation impact on your investment strategy?
Inflation influences just about every decision that is made within our investment strategy.
Investment Objective: The higher the expected or assumed inflation rate, the higher the cost or target value of your investment objective at a specified point in the future.
Additionally, if your stated objective is to invest for income and you do not pay attention to the capital base with which you generate that income then inflation will erode the purchasing power of that capital base as well as the income it generates over time.
Time horizon: Inflation is less important over short time periods than it is over the long term. The further away the investment objective the greater the scope for inflation to have an impact on price levels due to the compounding effect.
Contributions: The higher the expected inflation rate, the higher our end target value will be and the larger our contributions must be to reach our target.
Asset Allocation: Only certain asset classes consistently deliver returns in excess of inflation over the long term. Your asset allocation must incorporate a sufficient amount of these inflation beating assets in order for you to maintain or increase the purchasing power of your investments over time.
See our previous article on investing for income that goes into more detail on which asset classes typically allow us to earn real returns on our investments.
When you look at asset classes in the context of inflation you can quickly dispel some dangerous myths that have become part of the generally accepted investment philosophies.
The main one is that “Cash is low risk” – Cash and its equivalents will not beat inflation over any extended period of time and so it is essentially a very ‘risky’ asset class in the context of long term wealth creation. Equities or shares on the other hand have, over extended periods of time, delivered returns in excess of inflation. Equities therefore could quite conceivably be considered the low-risk investment option for those that want to genuinely create wealth long term.
Products purchased: Inflation will impact your decision over the choice of products you invest in. Once you reach retirement you will probably have to use your savings to invest in some form of annuity product. Annuities can be linked to inflation so as to protect you from an increasing cost of living into retirement or they can pay a flat amount. It is crucial to understand that even though the flat rate may be higher initially, it is guaranteed that inflation will reduce this benefit significantly 5, 10 or 15 years into retirement.
How can we combat inflation?
Unfortunately we cannot control inflation – The prices we pay for food, clothing and medical care can only be influenced at the margin by budgeting decisions we make, like the brands we buy or potential products we can substitute.
We must therefore view it as an unavoidable cost that must be managed and mitigated.
The only solution to combating the wealth destructive properties of inflation is to focus all of our long term investment activities on earning real returns.
A real return is a return in excess of all associated costs, of which inflation is one. The others are taxation and investment fees.
Consequently, to maximise our real returns, we need to:
– maximise our nominal (before costs) returns,
– minimise our investment fees
– minimise the tax we incur on our investment activities
– and very importantly, we must be aware of the realistic rate of inflation that we face
To maximise our nominal returns we need to invest in asset classes which have historically delivered returns that outstrip inflation so as to preserve the purchasing power of each Rand saved.
Property rental income that increases in line with inflation each year is a good example of building in inflation protection. Of course hopefully the value of the property is also increasing in line with or ahead of inflation.
Companies whose shares we can invest in should also generate earnings and dividends that typically increase in line with or ahead of the inflation rate over the long term.
Sticking your money in cash or a fixed interest bearing security will almost certainly fail to protect you from the ravages of inflation. You may not like the perceived risk of equities over shorter time periods (they can suffer periods of significant losses) but at least over the long term you have a fighting chance of creating wealth or at the very least maintaining the purchasing power of your savings.
A lesson in long term
One of the biggest mistakes we make over the long term is not gaining enough exposure to asset classes that give us the best chance of beating inflation because of the fear of losing capital short term.
Your asset allocation must be based on achieving real returns over the long term rather than on meeting your appetite for risk if you genuinely want to create wealth.
By getting to grips with how inflation will rob you of purchasing power over time and by understanding what the realistic expected returns of the various asset classes are over the long term, you will be better positioned to structure your investment strategy for success.
Please contact White Investments if you would like to learn more about the ways in which we can partner with you to a more secure financial future. E-mail: firstname.lastname@example.org