Simple Pound

Purchasing power risk is one of the most fundamental constraints you should always bear in mind when deciding how and where to invest your money. As much as compounded interest works in favour of any investor, inflation will always work against you and erode the real value of your money over time - if you don’t do your best to protect it.

The following table is taken from the book I’m currently reading (“The Art of Asset Allocation” by David M. Darst) and shows vividly how important capital protection is and what growth rates it requires over the years.

It is quite frightening to see that inflation at the 15% level would erode 96% of your money’s purchasing power if you kept it “safe” under your mattress. Obviously, most developed countries don’t face double-digit inflation rates anymore, but it is nevertheless an economic force that cannot be ignored. The list below (alphabetical by country name) should give you a reasonable idea of how much various countries are currently affected.

All figures express the year-on-year percentage change in inflation for March 2008, unless otherwise stated.

• Australia: 3.00% (December 2007)
• Bulgaria: 13.20%
• Canada: 1.40%
• China: 8.30%
• Colombia: 5.93%
• France: 3.50%
• Germany: 3.30%
• Iceland: 6.80%
• India: 5.20%
• Japan: 1.00% (February 2008)
  
• New Zealand: 3.44%
• Mexico: 4.25%
• Russia: 5.60%
• Spain: 4.60%
• South Africa: 9.8%
• Switzerland: 2.50%
• Turkey: 9.10%
• United Kingdom: 2.50%
• United States: 3.98%

It is immediately obvious that the inflation threat is more real in some countries than others - compare Japan and South Africa. To give you a better idea what sort of growth rates you need to achieve in order to simply maintain the purchasing power of your money, I have adapted the table above to show growth rates.

These are calculated by simply dividing 1 by the fraction representing the real value of your money after x years. For instance, if we assume that your money’s real value after 20 years at an inflation rate of 3% is equal to 0.54, then you need to nearly double your money to maintain purchasing power: 1 / 0.54 = 1.85.

So what can you do to achieve these growth rates?

• make sure the return on your savings account is positive in real terms (after inflation & tax)
• take advantage of tax-free savings and investments (ISAs, pensions etc.)
• if you want to play safe, inflation-linked gilts will always give you a fixed real return as they are linked to the current RPI (which includes mortgage costs and is hence usually a lot higher than the CPI)
• diversify your investments to reduce the impact of one asset class underperforming or showing negative growth rates
• avoid mutual funds with high entry and/or exit fees (where possible) as you will need even higher growth rates to just restore your purchasing power

A year ago on Simple Pound: Investment Choices - Bonds (I)

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