What do the following sentences have in common?

“In my day R100 was still R100!”

“I thought I had saved enough for my children’s education, but now we have to apply for a student loan.”

“Your biggest risk is not taking enough risk.”

“I used to be able to live comfortably on my pension, but now my medical aid premium is almost half of my monthly pension.”

The answer, of course, is inflation.  Inflation can be defined as “a rise in the general level of prices of goods and services in an economy”[1]  In everyday terms it simply means that our Rand can buy less and less over time.

Why is this of significance when we do our investment – and retirement planning? The most important dynamics that affect your planning strategy are risk, liquidity, taxation and inflation. Furthermore, inflation is one of the investment risks that cannot be eliminated through diversification.  This means that it is a factor that will always be in existence when doing financial planning and should never be ignored or underestimated.

Inflation is determined by using a basket of assets that is determined by the government and updated every four years.

Changes to the basket provide interesting insight in the changing consumer spending patterns over time.  Currently there are 412 products and services in South Africa’s basket, consisting of products and services that households spend the most money on.

It is interesting to note that some items that quite recently formed an integral part of our day-to-day tasks has now been removed from the basket due to a shift in the way we operate: Blank CDs and blank DVDs have been removed from the basket, together with pre-recorded DVDs, showing the current manner in which South Africans consume media and store data. Another indicator of these changes is the removal of postage stamps from the basket.

Other items that have been removed include tennis balls, teapots, electric fans, automated pool cleaners, sweet corn, tinned peas, Marmite, Bovril and board games.

Another indicator of our changing lifestyle is the recently included items: such as frozen pizza and pies, instant noodles, ready-mix flour, savoury biscuits and rusks.

An investor’s personal rate of inflation will, however, differ from that of the official basket and will be determined by the products and services required by each specific household.

How do we know how to prepare for and combat the negative effect of inflation?  The rule of 72 is sometimes used as a guideline to determine how long it will take for the purchasing power of money to halve at a given inflation rate.

We can look at the following example to illustrate the use of the rule:  If we assume an inflation rate of 6%, the buying power of our money will halve in 12 years according to this rule (72 ÷ 6 = 12).  Although this is by no means a fool proof method, it illustrates the importance of taking measures to increase the real value of an investment.

This is where the above adage “Your biggest risk is not taking enough risk” comes into play.  There are many possible meanings and interpretations for the word “risk” in the investment environment.  In this instance the phrase means that an investor will be exposed to the risk that inflation will negatively impact the investment portfolio if there are insufficient growth assets in the portfolio.  Growth assets (shares) are regarded as higher risk assets, since the asset class is exposed to high volatility, especially over the short term.  This led to the misconception that instruments such as money market accounts or funds and fixed deposits are low risk instruments.  Where it is certainly true that the capital value of the investment will not fluctuate like that of a portfolio with equity exposure, research has shown that the after tax return on cash will not be able to outperform inflation over the long term.  This means that a portfolio with too much cash exposure might not be exposed to high volatility over the short term, but will have a very high inflation risk. The concept of risk will be discussed in more detail in a separate article in future.

Conclusion:  Even though the eroding effect of inflation cannot be totally negated by diversification, a well-constructed portfolio can go a long way towards combatting this ever present threat.

Sources:

Premiums & Problems – Exam Edition No 115

https://techcentral.co.za/south-africas-inflation-rate-slows-4-4/79709/

http://www.statssa.gov.za/

[1] Premiums & Problems – Exam Edition No 115 Investment Planning B12