How to counter the impact of inflation on your long-term wealth
The dilemma facing savers is this: if they don’t beat inflation over time, they will effectively lose money. The purchasing power of their capital will be materially less even if the capital value of their savings has stayed the same.
In the pre-crisis days, the problem was not so acute: If a saver could pick up 3-4% on a savings account, the chances are, they were beating inflation. However, while interest rates remain low and savings accounts offer a measly 1-2%, it is a real risk.
According to the Bank of England inflation calculator, to protect the buying power of £5,000 over the past five years, it would now need to be worth £5,875. Any savings need to have generated a return of 17.5% to buy the same basket of goods that they could buy five years previously. http://www.bankofengland.co.uk/education/Pages/inflation/calculator/flash/default.aspx.
Another important point is that CPI only measures inflation on a limited range of goods and services, it does not include – for example – house prices, where inflation has been even stronger.
If savers accept that in the current market, a savings account is unlikely to protect them against inflation, where else should they look to preserve the purchasing power of their money?
1) Inflation-linked bonds – in a normal bond the income is fixed and therefore does not protect against inflation. For this reason, inflation is usually bad for bonds and will send prices lower. For inflation-linked bonds, however, the income moves in line with inflation.
2) The stock market – a less direct but possibly more effective means of inflation-protecting a portfolio is via the stock market. Companies can, in theory, put up their prices at times of higher inflation. Therefore, they are in a position to pay their investors higher dividends or see it reflected in share price growth.
3) Commercial property – Commercial property funds offer some inflation protection because landlords can put up rents at times when there is more demand, i.e. at times of economic expansion. This is returned to investors as higher income, or higher capital growth.
4) Alternatives – alternatives can be a dirty word for many investors, but there are some investments outside mainstream stock and bond markets that can offer effective protection against inflation. For example, infrastructure funds – that invest in domestic and/or global infrastructure projects, such as the building of schools and hospitals – provide a long-term high income, with built-in inflation-linked rises.
Commodities have long been considered a good inflation hedge. Fuel and energy prices form part of the measure of inflation, so if inflation is high, it can often mean that commodity prices are high. Equally, commodity prices tend to rise at times of buoyant economic growth, which is also when inflation rears its head.
The peril for investors is that by the time inflation worries emerge with any vigour, ‘inflation-protected’ assets are already expensive, and therefore – perversely offer less inflation protection. As a result, it may be best to hold inflation-protected assets in a portfolio consistently, rather than only when there is fear of inflation around.