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Why inflation is important and how it affects investors
Investors need to keep an eye on inflation because it affects different types of investments in in different ways.
by Gavin Lumsden on Feb 01, 2013 at 11:53
The aim of investing is to grow your money ahead of inflation so that you have enough to live on when you retire. The trouble is different types of investment behave differently depending on what the level of inflation is.
This is the latest video in The Lolly Investor Programme series, aimed at explaining the basics of investing to beginners.
Can't watch now? You can read my video script instead.
Hello, the whole point of investing is to protect your money from inflation so that you have enough to live on when you retire.
What makes this difficult is that different types of investment behave differently depending on whether inflation is high or low, or whether there is deflation, which is the opposite of inflation when prices are falling.
Inflation is an important issue to consider right now because the Bank of England is thinking of reviewing its policy target of keeping inflation at 2%.
Outgoing Bank of England governor Sir Mervyn King and his successor, the George Clooney lookalike Mark Carney, have both talked about whether the Bank should pay more attention to achieving growth in the UK economy.
This has got some alarm bells ringing. The Bank’s current target already requires it to balance the need to keep inflation in check with the need to have growth in the economy.
Modifying the policy target could risk the Bank being seen as soft on inflation, which would have huge implications for all our finances.
Mervyn King insists he is not soft on inflation.
However, under his watch the Bank’s record on forecasting inflation has been poor. In recent years inflation has generally proved to be higher than the Bank said it would be.
Britain’s most pressing need is to cut its £1 trillion pound debt mountain.
The most effective way to do this would be to restore economic growth.
But there is another way.
We could inflate our debts away. There’s a sneaking suspicion that’s what the Bank wants to do.
How would inflation reduce our debts?
We all know inflation increases the price of goods and services we buy.
For example, the price of a pint of milk rose by a third in the 10 years between 1999 and 2009, from 34p to 45p.
That’s happening all over the place.
As time passes inflation means your money is worth less.
The same happens to your debts: their real value falls under inflation, making them easier to pay off.
Suddenly inflation doesn't sound so bad!
Before you decide to become a fan of inflation bear in mind interest rates also rise with inflation, so the cost of servicing a lot of debt goes up too.
Nevertheless, this shows why some people think the Bank of England is prepared to let inflation to continue to rise above ‘expectations’.
And don’t forget the £375 billion of new money the Bank of England has created with ‘quantitative easing’ in response to the financial crisis.
The Bank has massively increased the ‘monetary base’ of the economy.
This has avoided a Depression but all that extra money sloshing around could risk a spike in inflation, unless the Bank can find a way of removing it once the economy starts to recover.
So what happens to investors if we get a bit more inflation?
Last year two US academics Kenneth Washer and Lee Dunham published an article looking at the performance of the main asset classes in relation to inflation between 1972 and 2011.
Their results are very interesting and although based on US markets, are relevant to UK investors.
In times of moderate inflation between 1 and 2% Washer and Dunham found shares were the best asset class.
On average shares rose 1.4% above the rate of inflation in each quarter when inflation was moderate.
This is probably because companies can push through price increases on their products and continue to grow their dividends.
Shares beat gold and property shares, although their returns were positive.
Bonds did worst of all, losing money in real terms as they returned 0.5% less per quarter than the rate of inflation.
In periods of higher inflation the investment picture changes entirely.
In quarters where inflation ran at more than 2% there was only one winner gold returned an average of 3.2% more than inflation in these periods.
Bonds again did badly as their fixed rate of interest is eroded by inflation.
But property shares and other shares did worst of all. High inflation made their dividends less attractive and share prices fell, returning 1.4% on average less than the rate of inflation in the case of shares.
These are challenging findings for investors. Property shares and ordinary shares only beat gold in periods of low inflation.
And in quarters where there was deflation or falling prices shares did surprisingly well. On average they returned 6.5% above the level of deflation, which averaged at minus 0.7%.
Deflationary periods were the best for bonds which returned 3.4% above the level at which prices were falling in each quarter.
To sum up, bonds are a very poor defence against inflation but shares do actually worse when inflation is high.
Gold is a brilliant defence against inflation which is why there has been so much investor interest in the precious metal in recent years.
Investors can only hope we find the growth solution to our debt problem. Using inflation to erode our debts would hit all our pension plans.
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