Inflation is something we are all vaguely aware of, but because of its complexity, have largely ignored its implications. Because of this, we are nearly all paying the price of inflation tax in one way or another, we just don't realise it. For example, over the past 10 years, second class mail prices have gone up over two and a half times - from 19p in 2002 to 50p in 2012.
An IC reader this week asked: "How much do I need to save for retirement?" In the context of inflation the answer may be more than you think.
Few investors pick a target income in retirement. Look no further than this week’s reader portfolio for an illustration of this classic error - the reader aged 47 wants to retire at 65 but says: "I don't really have any fixed plan and I don't know how much money I will need to retire". Even fewer investors factor in inflation to their calculations of target growth or income. But this is a big mistake.
Pete Comley, author of Inflation Tax: The Plan To Deal With The Debt writes about the "money illusion". This term refers to numerous studies that show people focus much more on the numerical value of money than on its real purchasing power (after you have factored in inflation). He says: "Adverts for certain financial services products can also exploit the money illusion. They might pressurise you to invest a certain amount each month and turn it into, say, £1m over 25 years, ignoring the fact by then £1 million would be worth only a fraction of what it is today. Indeed, if the same level of inflation over the last 25 years repeats itself over the next quarter century, you'll need to save up nearly £2.5m to have the same purchasing power as £1m today."
In choosing your investments concentrate on the 'real return' on an investment. If inflation is 3 per cent and your investment gives you 5 per cent (net of charges) then the real return is 2 per cent. Cash on deposit in the bank or building society has already lost 11.47 per cent of its value since interest rates fall to 0.5 per cent in March 2009 (Source: Hargreaves Lansdown). My colleague Chris Dillow points out that the real return on cash could be negative for several years. Consumer Prices Index inflation at today’s levels of 2.8 per cent will halve the value of your savings in 25.1 years. Today there is only one standard savings account to beat basic rate tax and inflation, a seven-year bond from Skipton Building Society at 3.50 per cent - too long a commitment for most savers.
So while we all need some cash reserves for short term needs and emergencies, investors with a time horizon of five years or more should shift surplus cash into riskier assets where there is a prospect of a real return after inflation. Gold has long been a traditional hedge against inflation. Equities also offer attractive inflation proofing as some companies are able to pass on any rises in costs to the consumer and therefore protect their profits.
In his book, Mr Comley considers equities, bonds, gold and international assets and concludes that equities are the best of the bunch. However, he also cites the historical evidence that shows there is not one type of investment or asset class available where you can be sure of protecting your money and beating inflation.
Patrick Connolly a chartered financial planner with Chase de Vere advises: "The best approach to generate a real return and effectively managed risk is to invest into a range of different asset classes including equities, fixed interest and property, in the right proportions to suit your circumstances, financial objectives and attitude to risk."
That is probably the most traditional investment advice you can get, but it's the best that most investors can do. If you are attempting something very different to this, sit down today and challenge your thinking.
*Pete Comley's book, Inflation Tax: The plan to deal with the debts, is available in paperback from Amazon for £9.99 and in ebook format for £4.99.
