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In simplest terms, inflation is the reason R100 this year can buy less than a R100 last year could. Economists usually define inflation as ‘a decrease in your money’s purchasing power over time’. Focus specifically on the word ‘time’ in that definition – inflation is something that is observed with the passing of time, the same time that is also an important input when growing an investment. For this reason, the longer an investment is held, the more cautious an investor must be of inflation eating away at its value over time. As with most things in life, if you know of the risk, you can plan to avoid it. And luckily there are strategies that can be followed to mitigate the effect inflation can have on your investments.
Let us first understand why inflation is a reality in our world. A healthy economy needs some inflation to ensure that it keeps on growing. In its purest and most basic definition, an economy is the supply and demand for goods and services and these forces are underpinned by the price at which a willing buyer and seller are prepared to trade these goods or services. The price of a particular good or service will increase if the demand for it increases, or if the supply decreases. Conversely, the price will decrease should demand for it be less or if supply rises. These principles are the forces behind inflation. There are two main drivers of inflation, namely ‘demand pull’ and ‘supply push’.
Demand pull is observed when the demand for a product increases while supply remains the same. Let us imagine there is a particular type of bread that uses high quality ingredients, which starts to gain in popularity. The big drive behind the increase in demand is that employment in the economy is picking up and thus consumers have more disposable income to buy such a premium type of bread. The baker, on the other hand, can’t increase his production of bread as fast as the demand is growing because the particular ingredients are limited. This will cause the price of the bread to increase to match the demand, which will ultimately lead to inflation.
Supply push, on the other hand, is caused by supply decreasing while demand remains the same. A real-life example of this is the current global shortage of computer chips, which has caused the price of computers to increase significantly.
It is clear from these examples that inflation is a very natural occurrence and can’t be escaped or avoided by investors.
Now that we understand what inflation is and why it occurs in the market, we can discuss the golden rule for mitigating inflation risk and, ironically, the answer lies in risk itself. Each asset class has a risk profile associated with it. Cash held in the bank has a very low risk because there are very few factors that can cause an investor to lose a portion of this investment. Equities (i.e. shares traded on the JSE), on the other hand, are considered a high-risk investment since there are many factors that can cause the investor to lose money invested in this asset class. The only justification for an investor to take on such high risk must be that the return is also increased. Cash, having a lower risk, will thus also have a lower return compared to an investment held in higher risk investments.
Although there are more risks associated with equities, especially over the short term, equities tend to follow an upwards trend over the long term because companies fundamentally grow based on a growing economy. This means that by tolerating more risk in the short term an investor can better grow the investment over the long term compared to a lower risk asset class.
As discussed earlier, inflation becomes problematic when investments are held over time. Although cash in the bank does not have too many risks, it will become less valuable over a longer period because of inflation. The little growth earned by low-risk investments over the long term will therefore be diminished by inflation and the only way to ensure decent returns over the long term is to have higher returns, which in turn is achieved by investing in higher risk asset classes.
To put it in simple terms, when investing money over a longer-term period, it is important to consider the effect inflation will have on such an investment. Do not let inflation intimidate you or deter you from investing your funds at all. By understanding what inflation is and by applying risk-mitigating principles like those above, you can ultimately beat inflation and ensure that your investments remain strong and rewarding.