For example, in 2009, a loaf of bread cost R5. Today, a loaf of bread costs R10, which means R5 will now only buy half a loaf of bread. Many would assume that inflation has increased the cost of bread, but the truth is that it is not the loaf of bread that has become more expensive, it is the value of R5 that has halved. This means that you need twice the amount of money today to buy the same loaf of bread you bought five years ago.
The economy has been suffering from the impact of a high inflation rate for the past two years. A high inflation rate is a reality that investors have to cope with in a developing economy such as this. Inflation is a slow, silent killer, which gradually erodes the value of money, and in turn the value of accumulated savings. Inflation can erode wealth over the years.
Time value of money
In financial circles, this is referred to as the “time value of money” – the very real phenomenon that the value, or purchasing power, of money halves around every seven years, depending on the inflation rate. This means that in seven years’ time, you will only be able to buy with this R5 what you can buy with R2.50 today – a quarter of a loaf of bread.
Effect on investments
When the ravages of inflation are considered in the context of retirement funds, it is clear why only 5% of South Africans who have retirement plans will be able to retire financially independent.
Let’s say that your retirement fund projects that you will have R22-million by retirement in 40 years’ time. What that R22-million will be worth in 2054 will depend greatly on the average inflation rate over the next 40 years, but two hypothetical scenarios will illustrate the point.
In the second scenario, in which inflation averages 8% over the next 40 years, your R22-million retirement fund will be equivalent to receiving around R850 000 today. That means that in 40 years’ time, when you retire, you will be able to buy with your R22 million retirement fund what you can buy with R850 000 today. Even if the inflation rate averages 5%, as in the first scenario, how long would you be able to sustain your current lifestyle with the equivalent of R2.9-million?
As it is the rate of inflation that determines how rapidly the purchasing power of money is eroded, and what investment returns will be worth at retirement, it is absolutely crucial to ensure that an investment provides a hedge against the ravages of inflation.
Hedging the risk
One investment that has proven to outperform inflation is buy-to-let property. Firstly, property price growth, while experiencing short-term fluctuations, continues to keep pace with inflation over the long-term. In fact, it is widely recognised that inflation boosts physical asset prices like gold, silver, oil and property.
Secondly, and similarly, the monthly rental income generated by a buy-to-let property keeps pace with inflation year after year, as the rental increases each year by the amount stipulated in the lease – generally 10% – or at least the inflation rate. This means that the income is hedged against inflation and will still have the same purchasing power – the rental of an average house – in 2024.
Buy-to-let property provides a real hedge against inflation, ensuring the value of your investments do not halve every seven years, but rather maintain their value, regardless of what the inflation rate may be.
To accumulate wealth, it is necessary for the year-on-year growth in accumulated savings to be higher than the inflation rate. If your accumulated savings are growing at a rate lower than the inflation rate, your savings corpus is actually shrinking as the value of rupee today will be lower than what it was at the beginning of the year. The rupee today will fetch lesser goods and services than what it did a year ago due to inflation. Hence, beating inflation is very important for any investor.
Evaluate real returns
Adjusting your portfolio to combat inflation earlier rather than later can make a big difference . Today, the interest rates of savings accounts and fixed deposits are paying interest rates lower than the inflation rate. After adjusting for taxes it is even lower.
Fixed deposit returns do not compensate for even food price inflation, let alone the total inflation. Money in a fixed deposit account that matures today will buy lesser goods and services than it did a few years ago, when the fixed deposit was initiated. So, despite earning nominal returns of say eight percent per annum, in reality, fixed deposits give negative returns in ‘real terms’ and reduce the value of investments in terms of ‘real value’ .
Invest in real assets
For this reason, investors must see to it that real returns on investments beat inflation . Gold is usually a very popular investment to combat inflation as it appreciates in value against a currency during inflationary times. Apart from gold and real estate , commodities, and stocks in the consumer goods sector are usually a good hedge against inflation in any portfolio .
Real estate is a great investment at any time, and it is even better during times of rising inflation. Limited availability of land and rising population growth will increase housing demand and hence real estate in general has the potential to beat inflation easily.
Impact of inflation on housing loan
Having said that real estate or property is a good hedge against inflation, it is important to understand the impact of inflation on housing loans. In India, 90 percent of property purchase is done through a loan.
Actually, inflation has a positive impact on a loan borrowed . The ‘real value’ of the rupee at the time of borrowing is much higher than its ‘real value’ when the loan is repaid. As the loan amount is not adjusted for inflation, the borrower is the beneficiary . However, the impact of inflation is felt through a rise in interest rates. As inflation goes up the interest rates rise to combat it. Consequently, the cost of borrowing goes up.
Planning for inflation
Investors have to plan their finances in advance to combat inflation. Here, a certain level of inflation is a given. That makes it easy to anticipate and plan for it. While making a housing budget, an investor should budget for an increase in prices of daily needs. You can factor in an appreciation say five percent in prices of all food items year-on-year.
Many individual investors do not understand the impact of inflation fully. Hence, it is imperative that they equip themselves with the requisite knowledge that helps them protect their wealth from further erosion.