The post-war years are often thought of as a time of economic stability, but the high inflation in the 1970s saw significant losses for savings and investors. Since this period, generations have become accustomed to low inflation. So what could rising prices mean for people with investments?
Inflation can be measured by the Consumer Price Index (CPI), which measures how much prices have risen by using a basket of everyday items such as food and transport fares. The rise in the cost of those goods is then added up for each month and compared with the same period from the year before. If there’s been an increase, you would expect inflation to be positive – but if prices fell, it would be negative.
Every year, the Office for National Statistics (ONS) publishes a new basket of goods and services – which it uses to measure inflation – and periodically updates its list for accuracy. The basket is made up of 750 goods and services, which makes up around 90% of household spending. It includes everything from bread and bicycles to kettles and stationery.
Retail Price Index (RPI) vs. CPI
The CPI is not the only way to measure levels of inflation in the UK. Since March 2003, the Retail Price Index (RPI) has been used as an alternative, although it does tend to be higher than many other countries’ official figures. This could be because it takes into account housing costs such as mortgage interest payments.
RPI includes housing costs such as mortgage interest, council tax and buildings insurance. In April 2012 , the ONS stopped using RPI after saying it had ‘serious shortcomings’ when compared to CPI. However, in March 2013, former chancellor George Osborne announced he would be bringing back RPI in line with inflation for State Pension increases in 2016. The previous government had dropped it in 2010 on the grounds that ‘it does not accurately reflect changes in spending patterns’.
What is deflation?
Deflation is when prices go down. This can occur if wages go up faster than supply or demand for goods, which drives down the cost of things. It was seen during 2009 when oil prices fell by about 60% within six months following a sharp downturn in economic activity. But deflation can be concerning because it can cause an economy to slow down further and is difficult to turn around once established .
This period of price ‘stickiness’ means that most products remain unchanged despite current market conditions. Falling income could mean people don’t have the money to pay for goods at their current prices, but large scale changes would still take time.
How inflation affects investments
Inflation acts as a hidden tax on people’s savings and investments, generally causing their real terms value to gradually diminish over time. Therefore, investors should not only look at the interest rate or return on investment (ROI) they are receiving but also consider potential loss of purchasing power due to inflation when deciding how to invest money.
Of course, it’s impossible to predict inflation with 100% accuracy but you can estimate its average yearly increase. The effects that inflation has on investments will also depend on which type of investor you are (conservative, moderate or aggressive), how much money you’re investing in general and what kind of timeframe you’re investing for.
Conservative investors (also called ‘defensive’ or ‘income-oriented’) usually seek to provide a steady income stream and protect their principal investment, so they tend to choose conservative investments with low inflation sensitivity such as bonds, money market funds and cash. They also often invest in government securities, which may pay interest that is not affected by inflation.
Conservative investors should keep an eye on the inflation rate when deciding how much to invest in each type of asset because even if some higher risk investments remain low-risk after adjusting for inflation, those gains will be impacted if there is deflation instead of inflation.
Moderate investors (also called ‘aggressive growth’ or ‘capital appreciation’) are willing to take on more risk in order to potentially achieve higher returns, so they can afford to invest more heavily in stocks, which are generally more sensitive to inflation. These investors should keep an eye on the inflation rate when deciding how much money they want to put into riskier investments relative to safer ones, because these investments may decrease in value faster if there is deflation instead of inflation and/or increase in value more slowly if there is inflation instead of deflation.
Aggressive investors (also called ‘speculators’) focus on high returns and quick profits and not only look at the interest rate or ROI they are receiving but also how fast their investment will appreciate or depreciate due to inflation. These investors should keep an eye on the inflation rate when deciding how much money they want to put in each kind of asset, because these investments can decrease in value faster if there is deflation instead of inflation and/or increase in value more slowly if there is inflation instead of deflation.
An understanding of the effects that inflation has on investments can help you make more informed decisions when it comes to managing your money.
So what should investors do?
There isn’t a ‘one size fits all’ answer to the question of whether inflation is good or bad for your investments. Rates of return and time scale are just two factors that can affect things, as well as general economic conditions such as employment and wages.
It’s not surprising that some people may switch their savings into cash. However, keeping too much money in cash could come with its own risks because of inflation – even if it is still relatively low.
Cash deposits used to be seen as the benchmark for safe returns but no longer offer protection against price inflation over time. This means you could see serious falls in value if you need to withdraw money from your account at short notice. It makes more sense to consider a range of investment products which have the potential to boost your earnings over time.
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