Methodology

Stocks

Module 2

Inflation

As mentioned in the previous sessions, if you are still deciding whether you should invest or not, an important thing to bear in mind is that not investing at all is a risk in itself. This is because inflation will reduce the value of your savings over time, making investing the only option to avoid that from happening.

 

An extreme example of the impact of inflation can be seen in South Korea, where the economy grew incredibly quickly from the 1960s to today. This growth pushed many elderly people into poverty, with inflation hitting highs of more than 30% a year in the 1980s. This happened as a consequence of the elderly people not investing, as their savings failed to keep up with inflation. The situation in Korea is unusual as the elderly population of a country are usually the richest group in society, but this is not the case there.

 

The situation in South Korea demonstrates the dramatic effect that inflation can have on your financial well-being. Therefore, accounting for inflation is really important when it comes to managing your finances. 

Rates of return and inflation

In order to overcome the issue caused by inflation, it is necessary to select investments that deliver a large enough return. In most develop nations, the government try to control inflation at around 2% a year. Therefore, in most cases, you simply need to identify investments that deliver a return that is generally greater than 2% a year, in order to reduce the effects of inflation.

 

As you may already know, cash investments generally offer the lowest returns, especially when interest rates are low. In recent times, the interest payments received from a bank on savings is typically less than 1% – which is not suitable to generate a return that is greater than inflation.

 

Bonds are more likely to deliver a return that at least matches the inflation rate, more so when it comes to corporate bonds. Government bonds are similar to cash investments and usually offer a lower return on investment (around 1% or less). Corporate bonds, on the other hand, are more suitable at this moment in time, delivering a return that tends to range from 3% to 12%.

 

Finally, stocks are arguably the best option in terms of consistently outperforming inflation. Stocks usually deliver a return that ranges from 7% to 30%, which is well above the standard inflation rate of 2%.

 

In order to know if your investment returns have outperformed inflation, you need to calculate your real rate of return. The real rate of return formula is: ((1 + investment returns) ÷ (1 + inflation rate of year)) – 1.

 

An example would be ((1 + 10%) ÷ (1 + 2%)) – 1, which equals 7.84%. 

Investing with very high inflation

If inflation is very high, it usually means that the economy is in distress. A consequence of that is that stock prices will fall, with the cost of buying materials/products increasing for companies. This increases the expenses of the business, reducing the profits that they can achieve – which is why the stock price of the company would fall.

 

In order to control inflation, the governments will increase interest rates. This makes it harder for businesses to borrow money, reducing the demand for materials/products. The knock-on effect is that companies will struggle financially or go out of business and are likely to make many of their employees redundant.

 

Gold tends to be seen as a traditional hedge against inflation and is a popular option when inflation is abnormally high. Gold outperforms inflation during times of high inflation, as a consequence of higher interest rates. The higher interest rates typically weaken the value of a currency, making it more expensive to buy gold, increasing its value.

 

With that in mind, it would obviously be better to invest in gold just before inflation becomes very high, to avoid paying a larger amount for the gold. Timing is a challenge with the last point, so it may be worth considering investing in gold during normal times if you are particularly worried about high inflation.

That's wrong - try again!