Web money

Inflation is a bigger risk than volatility for a long-term investment portfolio

Today, a Wimpy meal consisting of a burger, fries and a cold drink costs around R77. In 1972, such a meal cost about 47 cents. Today, a loaf of brown bread costs around R16. In 1985 it cost R1, rising to R5 in 2005.

As an example of the power of inflation, consider the impact of a 6% inflation rate over time on a hypothetical basket of goods. Ten years ago you would have paid R558 for a basket of consumer goods that today costs R1,000, compared to R311 twenty years ago and only R54 fifty years ago.

This phenomenon is known as inflation, consisting of the constant rise in the prices of goods and services.

Source: PSG Pretoria East

While inflation is usually calculated for a basket of goods and reported as a consumer price index (CPI), inflation rates can also be calculated for individual categories of goods. Therefore, you may need to consider the future cost of goods and services relating to you.

A vehicle that costs R250,000 today will cost R435,000 in 10 years and R1,000,000 in 25 years (assuming vehicle inflation of 5.7% since 1990).

Medical expenditure, currently R100,000 per year, will be R276,000 in 10 years and R1,270,000 in 25 years (assuming medical inflation of 10.7% since 1990).

A dozen rolls that cost R16.99 today will cost R97.58 in 30 years and 1 kg of lamb chops that cost R190 today will cost R1091.21 in 30 years (assuming a 6% inflation). This price increase due to inflation therefore applies to all products and services you can think of.

In other words, after 25 years, the current fixed monthly pension income of R15,000 per month will decline to around R3,500 per month in real terms (taking into account the impact of inflation), at a rate of assumed inflation of 6%. If we assume an inflation rate of 9%, we are looking at a decline in real terms to R1,740 per month after 25 years.

Source: PSG Pretoria East

Each person’s personal inflation rate is different, depending on what their inflation basket contains. The likelihood of your personal inflation increasing over time is high, especially since medical inflation is well above the regular consumer price index (CPI). It is therefore essential, even after retirement, to ensure that your investment continues to grow in real terms, ie that your returns beat inflation.

Inflation is therefore one of the greatest threats to any long-term investment and can regularly erode your wealth without you realizing it.

This risk begins before retirement and continues until retirement. Many investors who save for the longer term believe that swings and periods of negative growth pose the greatest risks. They therefore try at all costs to avoid fluctuations. What they fail to realize, however, is that inflation poses a much greater risk. Volatility is a risk that can disappear over time, the longer your time horizon.

The chart below highlights that volatility as a risk decreases significantly over time. Here we can see that for any rolling 10 year period (since 2002) the JSE has never underperformed inflation.

Source: PSG Pretoria East

Inflation, on the other hand, is a risk that increases over time. In ‘Finance 101’, you will never be taught that a fluctuating asset class such as stocks is less risky than a prudent investment in the money market. However, in the longer term (usually 10 years or more), you run a much greater risk trying to save by investing in a money market instrument, which is almost risk free, compared to for example an equity investment, which is much more volatile. .

An investor is therefore assured of becoming poorer in real terms in the longer term by investing in an investment linked to the money market.

In summary, here are some guidelines to keep in mind to deal with inflation and ensure that this “monster” does not surprise you.

  • Save as much as you can, as soon as possible, for as long as you can.
  • Increase your regular contributions to your long-term investments by at least inflation annually.
  • At retirement, your initial withdrawal rate should not exceed 5% if you retire at age 65.
  • With longevity (life expectancy) continuing to increase – which only increases the importance of accounting for inflation – most of us cannot and should not take our retirement at age 65.
  • Adequate exposure to growth assets, such as stocks, even after retirement is very important.
  • It is important to have a plan and a strategy to achieve growth above inflation. The pandemic has once again shown us how important it is to have a plan and stick to it. One could very easily have panicked and made an emotional decision and divested from the stock market when global markets crashed. You would have suffered a lot of financial damage and missed one of the strongest rallies to date and put your goal of above-inflation returns in grave jeopardy.