Beating Inflation with Investments
Inflation is the increase in prices of goods and commodities over time with demand and supply fluctuations. Economic growth with GDP, Government Interest rate policies, and market demand-supply rules all play a crucial role in determining the inflation rate. As individuals, we cannot control inflation rates, but we can mitigate its negative effects with financial planning.
Inflation and Purchasing Power
Government institutes issue inflation measurement through consumer price indexes. A CPI can only offer a starting point in measuring the effects though. Your money kept in bank accounts with interest rates below the inflation rate will deplete your wealth over time. If you do not put your money in any interest generating account, the wealth will further deplete.
Let’s say you can buy a pair of shoes for £250 today. With current CPI for inflation at 3%, the cost of the same pair would be £257.75 in 1 year. You needed to invest in an account with at least a 3% rate of return to cover the inflation interest. Without investment, you’ll lose wealth. In our example, your wealth has depleted by £7.50 over a year. Also, remember to count for the tax implications on your annual income. This is the case for keeping the inflation rate at a historic level, the inflation rates usually rise and move upwards. Although, sometimes inflation rates also decline.
Are Your Saving Returns Enough To Beat The Inflation Rate?
If you have surplus cash or a passive income source, you’ll surely put it in a bank savings account. If you can spare that money for a short period, say one to three years, it may be a good choice to put your money in bank savings accounts.
Special savings accounts and certificates of deposits (CDs) offer conservative interest rates. The returns with normal savings accounts range from 0.25% to 2.00%. Even the highest interest rate CD accounts cannot match the historic average inflation rate of 2.73%. Take into consideration, the tax rates of 15-20% (depending on your income slab) and the returns further deplete your wealth. A 15% tax rate implies your effective interest on CDs of 2.00% will be 1.70%.
Another problem with matching savings account returns is CPI rates do not consider real-life expenses accurately. That is why most experts, consider real interest rates or inflation-adjusted rates into account. Realistically, savings, or CD interest cannot compete with rising inflation rates and offer a wider gap. Either you can create alternative income streams or invest in higher-interest offering securities.
Individual Income and Inflation Rate
Economic indicators such as inflation rates can just provide an overview of financial markets. Your actual net worth with saving and earnings will depend on personal income and personal inflation. The concept of personal inflation works similarly to economic one.
With time individuals and families spend more with increasing needs and demands. Essential expenses, Debt payments like Mortgage and credit card bills, and lifestyle expenses all add up with rising inflation rates. Practically, the adverse effects of the personal inflation rate are far worse than the nominal or economic inflation rate.
As an individual, you can generate more income with multiple income resources to mitigate inflation risks. Passive income with high-interest rate investments is an effective way of beating inflation over the long-term.
Let’s take a glance at how investments are different from savings.
Savings Vs Investments
Investment requires allocating financial resources in an asset for an expected return (profit or loss). Essentially, investments are different from savings with the degree of risk involved with both transactions. With Savings your funds are utilised by the financial institution and they pay you a nominal return against your borrowed money. While investments take the form of active utilisation of funds in actual business activities (directly or indirectly), which makes the funds riskier. Investors look for higher rewards by lending their money to others. The risk-reward rule applies to all types of financial investments, savings and trade activities.
Similarities and Key Differences
You’re lending your money to others in both cases. Both savings and investments involve using lenders’ (or investors’) money and making profits out of it. The key difference remains with the degree of risk. Savings are safer and backed by the faith of borrowers’ creditworthiness hence offer lower returns. Investments are also backed by creditworthiness but offer higher risks due to funds utilisation fact with actual business activities or trading.
Practically, your chances of making or losing profits with savings are lower than with investments. That shouldn’t hold you back from investments, as there are various ways of fixed-interest and long-term investment options. Some long-term investments such as I-bonds also offer inflation-adjusted returns.
The Compounding interest effect with Investments:
With nominal savings accounts, you tend to spend the interest earned monthly. Even if you cannot make large investments, reinvestment profits can accumulate substantial rewards for you in the long run.
Let’s say you put £10,000 in a 3% Certificate of Deposit for a 5-year term. Without reinvesting the profits you can earn an interest of £300 yearly and £1,500 in total. If you reinvest the profits the total returns will be £1,615 even with the same interest rate of 3%. This is why compounding profits have a greater impact on wealth building that normal investment options. The caveat is saving and CD accounts do not offer high-interest rates matching inflation rates. The current average savings account is just 0.65% per annum.
What Are Your Best Options?
Inflation will eat up a large chunk of your income. There are various investments that profit with inflation too. A simple example will be with rising inflation rate, the interest rates also rise. That also has a double effect on you, as you’ll have borrowings and investments with banks.
Here are a few long-term investment options that can outperform the rising inflation rates.
Invest in High-Growth Stocks
These are special stocks that do not offer dividends. Investors look to make capital gains with share price appreciation over time. These are companies with good earning potential and strong market perception. For example, tech-based companies like Google, Amazon, and Facebook have performed spectacularly well in the last few years. With large volumes of sales and assets, a high price to earnings ratio, and stable financial indicators overall, these companies perform above the market average.
Stocks for these companies usually grow positively. Investing in high-growth stocks for the long-term can yield much higher capital gains. If you’re a risk-averse investor, consider investing in a high-growth index fund. Index funds comprise of different stocks that offer greater diversification as compared to the individual stocks.
Beating Inflation Invest in Real Estate
You can invest in real estate in two ways. Either you can invest with real estate assets such as a property e.g. a house or commercial shop, or invest in real-estate stock funds. Real estate prices tend to grow higher with increasing inflation rates it’s great to invest. As investors look to recover initial investments and hedge against risk, the real-estate prices often outdo inflation rates. You can increase net wealth accumulation with regular rental income and property price appreciation.
Diversify Investments with ETFs and Mutual Funds
Exchange-traded funds and Mutual funds offer greater diversification than investments in individual stocks. These are pooled funds based on the selection of stocks, bonds, commodities, or a combination of all. Mutual funds usually come with higher closing costs and fee structure than ETFs. Both long-term investment options offer higher rewards than normal savings or individual stock investments.
Mutual funds comprise of actively manages stocks and securities thus offer higher rewards. ETFs on the other hand, offer long-term passive income options with stable investments such as bonds.
Usually, bonds have an inverse correlation with interest rates. As interest rates rise, bonds lose value. That makes investment in bonds for regular income worthless unless realised for capital gains. However, Government Institutes offer inflation-adjusted bonds such as I-bonds and Treasury inflation-protected securities. The coupon rate for these securities is a combination of fixed-interest and adjustable interest rates. As the CPI or inflation changes, the total coupon rate with these securities also adjusts.
Investment options offer higher rewards but also increase the risks. As an individual, you may consider balancing between the risk-reward of high-interest investments. One way of managing the risk and adjusting to rising inflation is to take a step-by-step or recurring investment approach. Reinvestments and compounding profits is another effective tool to accumulate sufficient wealth over time. Consider short-term and high-interest rate investments and make reinvestments with inflation-adjusted rates.
The Bottom Line
The choice between putting your hard-earned with savings and investments largely depends on your financial profile. Evaluate your risk-appetite and risk-tolerance abilities before deciding on investment options. Bear in mind the inflation rates are more likely to rise than fall in the future. Match your existing returns with current inflation and compare the forecast returns for upcoming years. The interest compounding effect with reinvestment is an ideal example to understand the inflation effects on income.