Successful investment management is about effective risk management. In this post we explore the concept of 'Inflation Risk'.
Irrespective of whether your accessible wealth is exclusively cash, cash and investments or predominately investments, it is important to appreciate the nature and impact of inflation.
We all live with the fact that the cost of the goods and services typically rise over time. According to the Office for National Statistics, based on the Retail Prices Index, that increase has been 196% in the period from January 1987 to February 2021. In the first instance, most of us are concerned to ensure that our earned income keeps pace with, or ideally exceeds, inflation. If not, the pound in our pocket does not go so far and, if we want to avoid going into debt, we have to curb our spending.
For our cash savings we want to find accounts that provide an interest rate at least equal to the rate of inflation, otherwise we have to accept that the real value of those savings will fall. By that we mean the purchasing power – what you can buy with that money – is reduced. The recent period of historically low interest rates has made this a real challenge. Since February 2009 the Bank of England Base Rate of Interest been no higher than 1% and it is currently 0.10%. In contrast, the rate of inflation, as measured by the movement in the Retail Prices Index (RPI) in the 12-months to February 2021, was 1.4%.
For investors, the issue is largely the same, although it can be broken into two elements; protecting the long-term value of the money invested and maintaining a sustainable income.
To achieve growth greater than that available from cash, investors appreciate they have to put their capital at some degree of risk. In accepting that risk the minimum goal has to be for the real value of that money to grow over the medium to long-term. Most investors will have more ambitious and yet still realistic targets, but we should not forget the principle of risk vs reward: higher rewards are typically associated with increased risk of the permanent loss of capital.
When it comes to a receiving an income from an investment, inflation is most dangerous to those receiving a fixed sum. As for those with an earned income, this means that the money does not go as far. One strategy to mitigate this is to supplement income with withdrawals of capital. However, that replaces one risk with another: Longevity Risk. More on this in a later post.
Investors can try and increase the income received. This may not always be possible and it is not uncommon that the options to do so will place the capital at greater risk. It is a tricky balancing act.
In summary, inflation is a very important consideration for savers and investors. The aim for investors should be to achieve a rate of return that is comfortably above inflation over their time horizon, ideally through a diversified and carefully managed portfolio.
The contents of this article are for information purposes only and do not constitute advice or a personal recommendation. Investors are advised to seek professional advice before entering into any investment decisions. Please also note the value of investments and the income you get from them may fall as well as rise and there is no certainty that you will get back the amount of your original investment. You should also be aware that past performance may not be a reliable guide to future. performance.