Why must my investment beat inflation?

Key takeaways

  • Inflation is measured by the Consumer Price Index.
  • If you do not earn returns that are higher than the inflation rate, the buying power of your money will be eroded over time.
  • The longer you have to invest, the higher the return above inflation you should earn.
  • To earn higher above-inflation rates, you need to have a longer time horizon and take more investment risk.


Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man, former US president Ronald Reagan said.

When you notice how everyday items, like groceries, are becoming more expensive and you can afford less, you are experiencing the effects of inflation.

Inflation in South Africa is measured by the Consumer Price Index.  The index shows how the prices of a basket of goods and services change over time. The basket represents the buying patterns of the average household, so bear in mind it may not always reflect your reality, but at least it gives you some indication.

If the inflation rate is 4% for the year, it means your money’s ability to buy goods and services has reduced by 4% for the year. If your income does not increase by at least that rate for the year, your ability to buy what you need and want will decline – your buying power will reduce.


Growth means more than keeping up

Many savers fail to realise how inflation is robbing them when they are not earning an inflation-beating return.

Money under your mattress or in a low-interest savings account loses value against inflation, which is why you should only save in these accounts for shorter periods.

Any longer-term savings should grow by more than the inflation rate, or over time those savings will become worth less.

If your money only keeps pace with inflation, it will be impossible to grow your savings.

When you earn a return on your investments that beats inflation it is known as a real return. If inflation is 4% for the year and you earn 6%, your real return for the year is 2%. If inflation is 4% and you earn 9%, your real return is 5%.

Returns and risk

When you invest in financial markets, like the JSE or the bond market, the return you earn above inflation is linked to the amount of investment risk you take.

Over the past 90 years, an investment in the shares that make up the FTSE/JSE All Share index – an index that measures the performance of the JSE as a whole - have given investors an average return of 13.6% a year when inflation has been 6% a year, according to research into long term returns by Old Mutual. That is an average real return of 7.6% a year over this period.

But, you must remember this is the average for all the years. There have been years over this 90-year period when the shares that make up the All Share index have not only failed to beat inflation, but also shown losses.

However, your chances of making a loss when investing reduces over time and investing for longer terms gives you more certainty that your returns will beat inflation.

Old Mutual’s research shows that if you invested in the All Share index for any five-year period since 1995, your average return per year for those five years would be positive despite any losses in any individual year.

Inflation, investment risk and time in the market are closely related.

If your investment time horizon is shorter – a year or three years, for example – you should choose an investment with a lower risk of earning a negative return. The result will be a lower return above inflation – inflation plus one or two percent, for example.

If you have a long time to invest, you can afford to take more risk and earn a higher return above inflation and really grow your money.


 

Source: Old Mutual research quoted in this article is from The Long Term Perspectives 2021