Understanding the dangers of inflation

Former US president Ronald Reagan called inflation “as deadly as a hit man”. And, for any investor, it’s arguably the biggest enemy you face.

Part of what makes it so dangerous is that mostly you don’t notice it. Even though experience tells you that $100 today will buy you less than it did ten years ago, the erosion is normally so gradual that you don’t feel it happening.

With inflation at such high levels at the moment, however, things are different. Rising prices are having a very real impact in a short space of time. Energy and food costs are obviously going up and putting pressure on household budgets.

This is not how inflation usually works, but it is a reminder of how pernicious it can be.

Consider that, according to Stats NZ, a basket of goods that cost $100 last year would have cost just $51 in 1990. In 1970, you would have needed $6 to buy the same things.

Growing your money

That is how powerful the impact of inflation is, and why every long term investor needs to see it as the most important risk they face. To grow your wealth over time, you have to be getting a return that is higher than inflation.

Because otherwise, in reality, you are getting poorer.
If you are saving for your future, this is critical. Even if the amount of money you have is going up year by year, your ’real return’ is that return, minus the rate of inflation.
For example, if you earned a return of 8%, but inflation is 6%, only 2% is ’real’ growth. Inflation has eaten away the rest.

And if inflation is at 6% and you only earn a return of 4%, your 'real return' is -2%. You are actually poorer, because inflation has eroded all of your gains, and a bit extra.

Finding returns

What is really important for investors to appreciate is that in order to earn those inflation-beating returns, you do need to take a certain amount of risk. A perfectly safe five year fixed deposit at a bank is currently giving you around 4.4%. That is a higher rate than savers have been able to get for years, but it is way below the latest official inflation number of 7.3%.

For an investment that will earn inflation-beating returns over the long run, you need to be invested in things like shares and property. These will move up and down from month to month and even year to year, but over decades they are the only way to ensure that you consistently grow your wealth.

This does require investors to be patient. In some years, returns from the stock market will be below inflation. Sometimes, they may even be negative.

But a diversified portfolio of shares will also have very good years, way ahead of inflation. That means that, on average, you will be able to grow your wealth over the long term.

Keeping a long term mindset

But it’s not only investors who are saving for the future that need to think about inflation. Anyone who is using what they have saved to draw an income has to consider it as well. In fact, if you are in this situation, you now have to deal with inflation on two fronts.

The first is that your pot of money still has to keep growing to sustain you into the future. That means that you still need to keep a long term mindset.
Many people who are no longer working make the mistake of thinking that they can’t take any risk with their money. They only want to use ‘safe’ investments like fixed deposits.

These ‘safe’ investments are, however, very risky for a long term investor. That is because the returns they generate almost never keep up with inflation, which means that they erode over time. Someone who still needs to maintain their wealth for another 20 or 30 years can’t afford to let inflation eat away at their savings.

Growing your income

The second consideration for someone drawing an income from their savings pot is to make sure that what they are getting goes up every year. To maintain your standard of living, it must increase at least by the rate of inflation.

For example, if you are comfortable with a monthly income of $6,000 today, and inflation is at 7%, you will need $6,420 per month next year to afford the same things. If inflation moderates to 3% over the next 10 years, you will need $8,060 every month in a decade’s time.

If you don’t get any increase, the value of your $6,000 will decline. If inflation averages 3% for a decade, it will only buy you the equivalent of less than $4,500 would today.

This is why the inflation rate should be what everyone measures their investment performance against.

The return on the stock exchange or how much an individual fund or category of funds goes up doesn’t actually affect anybody directly.

What does impact everybody is inflation. Those who don’t beat it, will be getting poorer. And that is why it really, really matters to every investor, and is the most important measure of whether you are getting the returns you need.

Source: https://www.evidenceinvestor.com/understanding-risk-part-one-inflation/