Inflation is a reality that investors must cope with in most economies. Inflation effectively shrinks the value of your money over time, making it particularly important to find ways to potentially boost the returns on your long-term savings.
To understand the importance of inflation on investment, you should know of an inflation measure in every country which tracks how the prices of hundreds of household items change over time.
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There is an inflation measure in every country which tracks how the prices of hundreds of household items change over time.
What it signifies is if the index’s measure was at 1.5 per cent this month, if inflation were to stay at this rate for the next 12 months, this would mean a Dh100 spend would cost you Dh101.50 in a year’s time.
Inflation eats into savings
Another point to understand is to accumulate wealth, it is necessary for the annual growth rate 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 is shrinking.
An example to explain this: Let’s say you have Dh100 in a savings account that pays a 1 per cent interest rate.
After a year, you will have Dh101 in your account. But if the rate of inflation is running at 2 per cent, you would need $102 to have the same buying power that you started with.
You've gained a dirham but lost buying power. Any time your savings don’t grow at the same rate as inflation, you will effectively lose money. Hence, beating inflation is very important for any investor.
Let’s look at in detail how to ride out inflation as an investor and what are the best ways to go about it.
Proven metal remedies
Precious metals like gold and silver have historically outperformed inflation and are a very good hedge for any investor against rising prices.
If investing in physical gold poses problems like storage and getting the right quality, then gold can be bought in the tradeable form.
It is available through stock exchanges in the form of exchange traded funds (ETFs).
Such a method of owning gold is much more convenient as you neither have to worry about the quality nor haggle over the price and there’s no need to physically visit a goldsmith or a jeweller.
It is safe too as no storage is required, no threat of being stolen or lost.
Investing in real estate
During inflation, as the prices of all products and services increase, so do the prices of properties.
Therefore, once you buy a house on a mortgage at a fixed rate of interest, every year, you actually pay less (since the money devalues with inflation*). Also, the price of your property increases to make it a win-win situation for you.
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During inflation, as the prices of all products and services increase, so do the prices of properties.
Real estate investors, who purchase a property with the purpose of leasing it get the best deal. They purchase a property on mortgage and immediately lease it to tenants.
The rent received by them is used to pay off the installments and by the end of the loan tenure, they virtually have the house (with its increased price) as an addition to their portfolio with minimal investment.
With the evolution of options like Real Estate Investment Trusts (REITs) and Real Estate Crowdfunding, investing in real estate has become easier even for the small investor.
While most investment plans target to achieve inflation-beating returns, investing in real estate can truly be a great way to allow your money to grow with inflation.
If wages remain the same but inflation causes the prices of goods and services to increase over time, it will take a larger percentage of your income to purchase the same good or service in the future.
No to fixed deposits, investments
Fixed deposit returns do not compensate for 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.
Interest rates of savings accounts and fixed deposits generally pay interest rates lower than the inflation rate. After adjusting for taxes it is even lower.
So, despite earning nominal returns of say seven per cent per annum, in reality, fixed deposits give negative returns in 'real terms' and reduce the value of investments in terms of 'real value'.
Investors should ideally wait for interest rates to go up before locking into fixed deposits.
It can also be particularly harmful to fixed income returns. Fixed income investments, such as bonds, aim to produce a stable income in the form of interest, or coupon, payments.
As these payments are fixed, if inflation rises, their purchasing power (financial ability to buy products and services) declines.
Investment bonds are similar to fixed deposits in this sense. This is because they too involve investing a sum of money for a stipulated time frame.
While FD interest rates are much higher than investment bonds, investment bonds offer more tax benefits.
What you should instead focus your portfolio on are shorter-term bonds and then you will have less exposure to future inflation.
This is due to the fact that when those bonds mature you can go out and buy new ones. What happens when inflation is rising is that interest rates tend to go higher as well.
Focus your portfolio on shorter-term bonds and then you will have less exposure to future inflation.
Invest in inflation-linked bonds
You could also invest in inflation-linked bonds, which automatically rise in value along with inflation.
Inflation Indexed Bond are government treasury issued bonds issued, which provides the investor a constant return irrespective of the level of inflation in the economy.
The main objective of these bonds is to provide a hedge and to safeguard the investor against macroeconomic risks in an economy.
If you're anxious about inflation, you'll get peace of mind if you own some of these.
Because they reduce uncertainty, inflation-indexed bonds are a popular long-range planning investment vehicle for individuals and institutions alike.
This contrasts with other types of securities, which often decrease in value when inflation rises.
They are tied to the costs of consumer goods by an index, called Consumer Price Index in US and most countries or known as Retail Price Index in UK. They have a face value at issue.
Once they are in the market, they are traded like any other asset, with the price determined by the market’s expectations of future inflation.
The interest payments of these bonds and value at redemption are adjusted for inflation.
If you're anxious about inflation, you'll get peace of mind if you own some inflation-linked bonds.
Here is an example to understand the basic mechanism of these bonds to make it easy to understand.
Assume that the annual coupon, that is, the amount the investor receives at the end of the year on his bond investment, is 7 per cent, and he has invested Dh1,000 (his principal).
In this case, he originally would have been paid Dh70 at the end of the year. However, assume that the inflation index for the year is 10 per cent.
Through an IIB, the 7 per cent coupon is applied to new principal of Dh1,100 (10 per cent of Dh1,000 + Dh1,000). This comes to Dh77 plus Dh100 increment on the principal. Thus, the investor is sure to generate a return higher than the inflation rate.
The global volume has increased tenfold in the past decade, with the United States, the United Kingdom, France, India and Canada among the largest issuers of these securities.
In the United States, these bonds are known as Treasury Inflation-Protected Securities (TIPS) and inflation-indexed savings bonds (I-Bonds) and they are tied to the value of the consumer price index (an indicator of the variation in prices for retail goods and other items) in US and sold by the US Treasury.
In the United Kingdom, IIBs are called inflation-linked gilts, which are issued by the UK Debt Management Office and linked to that country's retail price index (RPI, an index like that of US CPI).
The Bank of Canada issues what are similarly called Real Return Bonds, while India’s Inflation-Indexed Bonds (IIB) are issued through the Reserve Bank of India (RBI).
Not all stocks beat inflation
Despite the lack of confidence most people express about stocks, owning some equities can be a very good way to combat inflation.
Some of the best stocks to own during inflation would be in companies that can increase their prices naturally during inflationary periods.
Despite the lack of confidence most people express about stocks, owning some equities can be a very good way to combat inflation.
Commodity resource companies are one example. Products like oil, grains, and metals enjoy pricing power during periods of inflation.
The prices of these items tend to go up as opposed to, for example, the price of a computer, which is subject to manufacturer and distributor price adjustments.
Still, price increases aren't enough to protect against inflation. If a company experiences rising expenses, price increases alone are not enough to maintain equity appreciation.
That's why grocery stores, which may benefit from an increase in food prices, may also suffer from an increase in their cost of goods sold.
Look to invest in businesses such as commodity firms or healthcare companies that possess the strongest profit margins and, generally, the lowest cost of production.
Finally, never underestimate the value of dividends during periods of inflation. Dividends increase the total return of a portfolio.
Never underestimate the value of dividends during periods of inflation.
