Cape Town - Investors are often uncertain about the impact of inflation on their investment portfolios, and how to stay ahead of inflation to protect their investment returns.
This is especially worrisome for people who depend on a fixed income from their investments, such as retirees.
Financial advisers play an integral role in helping clients understand the role of inflation, and guiding them towards well-informed decisions about their financial future and wellbeing.
So what exactly is inflation, what causes it, what effect does it have on investments and - most importantly - how you can beat it?
Discovery Invest’s FUNDamentals series explains inflation and how it could affect your investment portfolio.
What is inflation?
Inflation can be defined as the perpetual rise in the general level of the price of goods and services over time.
When inflation rises, the purchasing power of your money drops. For example, if the inflation rate is 5% annually, then theoretically a pack of chewing gum which costs R1.00 today will cost R1.05 in a year’s time.
What causes inflation?
There are two generally accepted theories on what causes inflation.
The first is “demand pull” – if demand is growing faster than supply, prices will rise. If there is over-supply and lacklustre demand, they will drop.
The second is the “cost push” theory – when companies’ costs go up, they need to increase prices to maintain their profit margins. Increased costs can include things such as salaries, taxes or petrol.
How is inflation measured?
Government statisticians measure inflation by compiling a basket of goods that is typically representative of the average consumption basket. This is referred to as a “market basket” or “consumer price index (CPI) basket”.
The cost of this basket is compared over time, measuring the cost of the CPI basket today as a percentage of the cost of the basket at, for example, the start of the year.
There are two main price indices that measure inflation. The first is the CPI. This measures price changes from the perspective of the buyer or consumer.
The CPI measures price changes in consumer goods and services such as petrol, food, clothing and cars.
The second is the producer price index (PPI). The PPI measures price changes from the perspective of the seller.
It measures the average change over time in selling prices by domestic producers of goods and services.
How does inflation affect my investments?
Inflation reduces or erodes the purchasing power of your investment portfolio. This means that if your investment doesn’t grow at least in line with inflation, you may be unable to sustain your standard of living in retirement.
For example, local inflation has been 5.9% on average, on an annualised basis, since 2001. If you were invested during this time, your investment would need to grow by at least 5.9% per year to protect its purchasing power.
Reviewing inflation-adjusted returns
Inflation-adjusted returns are simply the returns on your investment after you have factored in the adverse effect of inflation.
For example, since 2001 the annualised average return on local property has been 21.2%. With 5.9% inflation, an investment in property during this time would provide 15.3% inflation-adjusted returns.
The annualised average return on local equities during the same period has been 16.2%, so your inflation-adjusted return on investment in equities would be 10.3%.
However, you need to consider that as an investor, you are unlikely to be exclusively invested in property, equities or bonds. You will probably favour a diversified portfolio, which would be made up of several different asset classes.
Make sure you know your facts, and check the current inflation rate. It is important to periodically compare the rate of inflation with the return on your investments, and to regularly discuss your inflation-adjusted returns with your financial adviser.
How to inflation-proof your portfolio
The strategy you follow to make sure your investment portfolio is inflation-proof largely depends on your estimated time to retirement.
If you are under 55 and still have a number of years ahead of you before you retire, you can afford to consider riskier assets such as equities and property, which provide the potential for higher inflation-beating returns over the long term.
These asset classes have been known to experience more volatility in the short term, but provided you are some way from retirement, the effects of volatility over time are significantly reduced.
If you are over 55 and nearing retirement, the need for caution with your portfolio becomes greater.
Ideally you should consider less volatile investments and asset classes with more certainty of returns, such as cash.
A more modest allocation to higher risk assets such as equities or property may be suitable at this stage, depending on your personal circumstances and the counsel provided by your financial adviser.
* Do you have a pressing financial question? Post it on our Money Clinic section and we will get an expert to answer your query.
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