Inflation can affect your investment in many ways.
The high inflation of the 1970s and 1980s seems like a bad dream after the low inflation of the 1990s. Now we almost take low inflation for granted. However, even in a low inflation environment there are still implications for investors. Inflation can be one of the biggest enemies of an investor. Investors need to be aware that inflation overtime, erodes the value of their dollars and increases prices of the things they buy.
Understanding how inflation works can help in protecting yourself from it in the future. The graph below gives a brief history of inflation in New Zealand.
How do you measure inflation?
The CPI is the most commonly used index to track inflation. This tracks the average movement across a basket of goods and services within New Zealand. This gives a measure of the overall impact of inflation across the economy. For the last ten years the CPI has stayed below 3% in New Zealand.
With inflation being so low do we still need to worry about it?
Even though inflation is currently at very low levels, it still has a significant impact on your purchasing power over an extended period of time. When you look at the figures they don’t paint a pretty picture. Consider this question what would $10,000 be worth in the future.
Assuming the inflation rate stays at 2% what would your $10,000 have shrunk to in today’s dollar equivalent.
The ‘Cream Pie’ diagram above illustrates that even in a low inflation environment your money can be eroded due to inflation. Planning can help protect you against this inflation loss.
What causes Inflation?
Basically, inflation is caused in an economy when demand exceeds supply. When there is more money circulating throughout the economy attempting to purchase a limited supply of goods and services, prices will tend to rise. All while the value of the money you have is decreasing.
Can Inflation be ignored?
If you ignore inflation, you’ll probably be more conservative in your investing and put more money into fixed-income or cash investments because they are more secure. This may seem like a safer strategy, but in reality it can be one on the riskiest strategies that you can adopt.
Wise financial planning always takes into account the effects of inflation.
Just do the sums:
Assume a 6.75% term deposit rate (based on average rates at present) investing in cash has in the past been the traditional way to avoid the risk of your capital decreasing.
Taking inflation into account can alter your perception of the ‘safety’ of investing in cash assuming a 3% inflation rate. This leaves you with an actual return of 3.75 %, not exactly a good return when you consider having to pay tax on the total 6.75% at present the Resident Withholding Tax is 19%.
Taking just these two factors into account shows a dramatically different picture to the original rate.
Protecting yourself from the effects of Inflation
- Always assume that inflation is going to be around, even in our current low inflation environment.
- Consider investing in areas that pay higher returns than the rate of inflation, but remember that there are other costs to add as well.
- Try and save as much as you can each year.
Remember that inflation can have an impact both before and after your retirement.