What is inflation and how can it disrupt your investment plans?

Inflation is one of those topics that is important; it can be quite impactful on your investments and spending power, but, for many it is not very interesting or exciting. We can’t promise we will make it exciting, but we can at least attempt to make it relevant so you know what impact it can have and how you can manage your financial lives taking inflation into account.

What is Inflation?

Inflation is the increase in prices for goods and services in an economy over a period of time. It is typically presented as a percentage increase from one year to the next. If inflation is 2% per annum, that means that most goods and services cost 2% more than they did in the prior year.

Inflation is important because it erodes purchasing power. As inflation increases, the value of money, that is, the purchasing power of money, falls. Readers will have experienced this when they see items at the shops increase in price over time, and they can buy fewer items with the same amount. To keep pace with the increase in prices, wages need to be adjusted. You need to earn more so you can spend more, and the inflation cycle continues. If wages do not increase to keep pace with the higher cost of living, the standard of living you experience, will decrease.

Here is a graph, courtesy of Waverton Investment Management that shows the difference between the nominal value of money in the bank over a 15 year period versus its inflation adjusted rate.  This illustrates the impact of inflation clearly.

How this can impact your plans

When you are making long term plans, inflation must be taken into consideration. A good case study is retirement planning. If you believe you need to achieve €3,000 per month income to cover your cost of living at retirement, and you make that calculation at today’s prices, you need to adjust that for inflation. An income of €3,000 per month will have considerably less purchasing power in the future. At average long-term inflation, if your planned retirement date is 25 years away, after adjusting for inflation, you might need double that amount.  Furthermore, if you plan to live a healthy life in retirement for another 25 years, your cost of living might double again. In raw numbers a goal of €3,000 per month at age 35, is more like €6,000 at age 60, and €12,000 per month at age 85!

Inflation and interest rates

In the current markets, inflation is higher than interest rates. As most readers will have experienced, the interest rates you get from banks are about zero. Some banks will offer very low interest rates, but many banks in Europe are offering negative interest rates for larger amounts!

At the same time, inflation is expected to move closer to 2.5% per annum this year which means there is a negative differential between inflation and interest rates.

If that difference were positive, it would make sense to put your money in the bank. You would get a return and stay ahead of inflation, maintaining your purchasing power.  In the current market it is the opposite. You get no returns from the banks and you are losing purchasing power by the inflation rate every year.

Herein lies a risk to achieving your investment goals.

Where leaving your money in the bank may seem safe, it is in fact a guaranteed way of losing money over time.

Many investors are facing this risk right now. Non-cash financial markets, such as shares as measured by the stock markets are generating strong returns. Following the logic of what goes up must come down, some investors are choosing to sit in cash until the inevitable market correction. But is that the right thing to do? The answer, for you specifically depends on your personal situation. In general, it might not be the best decision. Timing the market is very difficult, if not impossible. Often, a market turn, down or up, can only be seen after the event when looking at historical charts. By the time you can see it, it is too late.

If your timeframe is long-term (10 years plus) you should probably be invested in a diversified manner across a range of asset classes, appropriate for your risk profile and your return objective. Sitting in cash will mean you will probably not achieve the results you expect or need.

The effect of the coronavirus pandemic

As the virus spread around the world in 2020, the economy slowed. Output reduced, demand for goods fell and the opportunities to spend money evaporated. This resulted in less money circulating in the economy, which meant inflation fell.

To support businesses, the general population and economies, many governments and central banks took economic stimulus actions, both fiscal stimulus and monetary easing. That is, they provided support, lowered taxes and printed money. This resulted in more money flowing through the markets, boosting the economies, which is in part, why some stock markets performed strongly in 2020. The increased flows of money into the markets has caused inflationary pressure though and latest figures show that inflation is increasing.

Inflation in the future

There is a concern that inflation will be higher in the next ten years than it has been for the last decade as we emerge from the pandemic and deal with the effects of the stimulus actions.

If that happens it is even more important that you make sure your wealth keeps pace with inflation., but at the same time if can be difficult to do so. An increase in inflation may cause a stock market reduction in returns as it adjusts to the new rate.

One of the best ways to protect yourself will be to have a diversified portfolio that is appropriate to your situation and your goals. It is suggested that such diversified portfolios may be less risky than simply keeping your money in cash in the bank.

Contact us if you would like to know more or discuss this in relation to your specific circumstances.