Inflation: What you don’t know can hurt you

When people think of inflation, certain iconic images come to mind.  Like schlepping wheelbarrows full of cash to the corner store to buy a loaf of bread; or even burning dollar bills, because they are worth less than fuel or firewood. Indeed, those things actually happened. Fortunately, inflation rates that extreme cause so much economic damage that they (thankfully) can’t last for long.

In most cases, inflation is much less dramatic, but alas, no less devastating. Canada’s inflation rate has averaged around 3 percent per year since 1915. So, while you probably won’t ever need a truck full of cash to shop for groceries, what you get for your money will continue to erode, slowly but surely, over time.  The good news? You don’t have to stand and let it happen.

Inflation as a force of evil
What could be better than the good old days when you could buy gas for pennies a litre and a new car to put it in for less than $1,000? Perhaps you’ve heard stories from your parents or grandparents about how they could buy a chocolate bar for a few cents. These days, that same confection costs considerably more, leaving many people to view inflation as a money-sucking force of evil (we need our chocolate). What people often forget, however, is that wages were much lower back then too. In fact, disposable income rose steadily in Canada before peaking and levelling off in the early 2000s. What this means is that while some things might have been cheaper back in ‘the good ol’ days’, we still have considerably more to spend on things beyond the essentials than our parents or grandparents ever did.

Inflation and your money
If inflation isn’t all bad, why is everyone always talking about it? The answer is simple.  Inflation in itself isn’t a bad thing; it’s what it does to your money over time that totally, well, sucks.

Unfortunately, many investors don’t even take this erosion into account. That’s because most investors are too focused on not losing money. And while that’s certainly important, we’ve got some bad news for conservative, GIC-loving investors: inflation can turn a small return into a negative one.

So let’s look at how this works in practice...

Your retirement money doesn’t buy much
Perhaps you’re aiming to save enough so that you’ll have $50,000 per year to live on during retirement. The problem is, the time you say goodbye to working for a living, $50,000 will buy considerably less than it does now. To be more precise, it will only take about 24 years before that $50,000 will buy about as much as $25,000 does today. And if you’re doing all your saving in a GIC, you may have a problem. With inflation at just over 2 percent and GIC rates at about 1.8 percent (at time of writing), these low-risk investments are essentially losing money every year – or at least in terms of how much that amount of money will be able to buy.

So does this mean you have to kiss your retirement reveries goodbye and settle for scraping on Canada Pension? Not if you invest right. This means setting up a portfolio that will beat inflation, allowing your money to grow enough to help ensure that you have enough to maintain a reasonable standard of living in a time when that lifestyle will cost considerably more.

How to do that? Let’s look at a few inflation-beating investments...

Anti-inflation investment plan
Historically, there are a few key investments that have worked to protect investors from inflation. Some do it producing higher returns, while others accomplish it maintaining their purchasing power. Either way, consider bolstering your portfolio with some of the following:

1) Stocks
Inexperienced investors are often terrified of stocks. After all, the stock market crashes. Companies go bankrupt. People lose money. We won’t sugarcoat it. Yes, they do. But over the long term, stocks have an inflation-adjusted return rate of between six and seven percent. Great stocks do even better. So how do you choose one of those winners and balance out your asset mix diversifying? Either get stock-market savvy or hire an advisor. Stocks have risks, but they also have the potential for returns that no-risk investments just can’t touch.

2) Real return bonds
Most bonds aren’t known for stellar returns. Real return bonds are no exception, but they’re still a great way to combat inflation. These bonds are bonds issued the Canadian government and pay interest on an inflation-adjusted basis. This ensures that if you invest $1,000, the end result will be an amount that will buy as much as that $1,000 could when you entered into the investment. Many investors aim to have a certain amount of money at retirement. If you are less concerned with how much, and more concerned with what it will buy, then real return bonds are just the ticket. Plus, the Canadian government tends to make good on its debts, so this is one investment that offers a lot of safety.

3) Real estate
There’s an old saying in real estate: Buy land, they aren’t making any more of it! While real estate investments have had their ups and downs recently, there’s still some truth to that old adage. Historically, real estate has returned about 5 percent per year on average. That’s less than stocks, but unlike stocks, this investment is unlikely to crash and become worthless. Real estate also provides the potential for rent, which sweetens the deal providing some income for investors.

4) Gold
Forget diamonds – it’s gold that has proven to be a friend to investors. Although the performance of the shiny stuff has been less than golden recently, its purchasing power hasn’t changed much for centuries. Many people love gold because it’s a physical commodity – you can buy it and hold it in your hand. That’s a lot different than stocks and bonds, and why gold enthusiasts maintain that it provides an added layer of security. The value of gold doesn’t really grow over time, but it can act as a stabilizing force - and provide a shiny life preserver when our currency is weak. As an anti-inflation investment, we say bling it on!

Going out on a limb
Investing is all about balancing risk with return to produce the best possible financial outcome. The reality, though, is you can’t beat the steady, predictable grind of inflation without going out on at least a little of a limb.

Suffice it to say, the days when you could buy something for pennies are long gone. (Come to think of it, we won’t even have pennies soon.) That’s why when it comes to long-term investing, what you save and earn aren’t nearly as important as what those assets will be able to buy. saving hard and investing smart, you can build a portfolio that will grow to meet your needs in the future, rather than being swallowed up price increases.  With a little risk, comes reward...