When the average person thinks about inflation, we usually think about the cost of living. Although it may be true, we don’t consider what inflation does to our savings and investments. Find out why keeping money under the bed is a bad idea.
Although we all save and invest for various reasons, we save and invest our money because we want to secure a financial future. You might want to secure an emergency fund, retirement fund, saving for education or something simple like a vacation. Whatever you are saving and/or investing for, you can’t escape inflation.
Inflation affects everything you purchase, and it keeps rising. And worst of all, you can’t avoid it.
Sam Ewing, a former baseball player said it best. “Inflation is when you pay fifteen dollars for the ten-dollar haircut, you used to get for five dollars, when you had hair.” This is a great example of how inflation rises dramatically within a very short time.
You won’t be able to purchase the same goods with a R10 note today, compared to a R10 note 20 years ago. That’s inflation for you, it challenges our standard of living.
You should always take inflation into consideration when planning for your future. That R2 million you are saving up for retirement won’t be worth R2 million by the time you retire.
So when we’re constantly dealing with inflation; how do we make the most out of our savings and investments?
How inflation steals your money
The constant rise of inflation affects the value of our currency and impacts the average price of everything in our economy. As everything become more expensive, our money becomes less powerful.
However, some economists believe that some inflation is good. An increase of about 2-3% a year is considered to be healthy inflation. The idea is for inflation to outperform Gross Domestic Products (GDP) by a small amount. The GDP is the value of all goods and services produced in an economy over a specific period of time. This small increase keeps the economy moving forward.
That becomes important because it means that there will be an increase in wages, corporate profitability and a flow of money in the economy. As long as everything rises together, inflation should not become detrimental.
To make things easier to understand, let’s talk about burgers. If it costs you R50 to buy a burger today and the yearly inflation is 10%. That same burger will cost you 10% more, or R55, in a year’s time. If your salary does not increase at the same rate, eventually you won’t be able to afford that burger.
How inflation affects savings
Inflation is bad news for our savings accounts. As inflation rises over the years, our buying power decreases. Buying powers is the amount we have earned from our savings or investments.
Let’s assume you had R100 in a savings account that earns you 1% interest at the end of the year. Once the year has come and gone, you’ve earned R1 to that savings account, so you now have R101.
Which is great.
But what if the inflation was at 2% for that year? You would have gained R1, but lost buying power. That means you haven’t earned any additional funds to add on to your savings account.
If your savings do not grow at the same rate as inflation, you’re actually losing money.
How inflation affects investment
Investors want their investments to grow well above the inflation rate so that they can meet their goals.
Although the stock market is unstable, investments have historically proven to be profitable. This is true even when inflation is on the rise. Companies generally rake in higher profits during rising inflation periods. That’s because prices rise along with inflation.
During high inflation periods companies seem to be doing well. However, like we’ve mentioned before, inflation affects the value of our currency. As inflation increases, the value of currency starts to decrease. People are now paying more for the same products, because the currency is not as strong as it used to be.
That does not mean the companies you’re investing in will not perform. If a company is performing well regardless of inflation, the investment will perform well against inflation.
A study which was done in 2016, in the UK, shows how £1,000 would perform in three different scenarios. The study stored money in cash, an average savings account, and an average global equity fund. The study looked at how the £1,000 would perform in the scenarios from 1995 to 2015.
Find the article here.
The study shows that holding on to cash loses the most value over time, as expected. Keeping your money under the mattress is not the best idea if you want to make it last. A saving account would perform slightly better, but still loses quite a significant amount. That’s because over long periods, the savings account would perform below the inflation rate. Some individuals who moved their savings around between the best savings accounts may have achieved better results.
The study shows that investing in the stock market over a long period of time would earn investors real value for their money. Whereas savers would struggle to keep up at the same level due to the interest rates lagging behind inflation.
The study shows that the stock market still performed well even during the dotcom crash and financial crisis. But even though this study shows that investments perform better than a savings account over time, investors have to keep in mind the volatility of the market.
Make the most of inflation
Unfortunately there’s no bulletproof method that protects you against inflation. But sticking to the basics will come in handy in the long run. Keeping your money in a savings account will benefit you for short term savings goals. While keeping your money in an investment over a long period of time will really make a difference.
Diversifying your returns is always a great idea and during inflation this might just protect your returns.
Inflation has a toll on your personal life. So keep your investments relative to your income. With inflation playing a role in how you spend your money, you should adjust your investments according to these changes.
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