How does inflation work?

In 1986 The average house price in Ireland was €37,000. Today it is €275,000 – an increase of nearly 600%. To put this in perspective, if you had purchased a house in 1986 costing €37,000 and sold it now for €275,000 your money would be worth over 7 times more (€255,000). This difference is due to inflation.

Impact on savings or investments

Many people don’t consider inflation when saving or investing.

A few frequent things I hear when conversing with clients regarding their savings or investment are “I don’t want any risk,” and/or “I am content with my money on deposit, it’s safe.”

However, from a value of money perspective, keeping your money deposited isn’t as secure as you might believe.

People don’t factor in inflation

One of the clear impacts inflation has on your savings is that it decreases the purchasing power, which means that if you save €100 today and there is a 2% inflation rate, next year you will only be able to buy €98 worth of goods with that money.10 years down the road, you might think you would need €120 to have the same buying power as today, but because compounding occurs with inflation ,you would actually need slightly more than €121.

The picture become slightly bleaker when you consider the current rate of inflation in Ireland at a whopping 10%.  This means that you would need €231 in 10 years to have the same buying power as today.

Compounding effect

Though it may seem innocuous, inflation slowly chips away at your wealth over time. In a single year, the average rate of inflation is only 2%. But as years pass, that number snowballs–and compound interest becomes an even more powerful force. Nobel Prize-winning physicist Albert Einstein called compounding interest the most powerful tool on earth.

Compound inflation is the reverse of compound interest–working against you instead of for you. To put it simply, this means that over time, your money will be worth less and less due to rising prices. For example, if we looks at the effects of 2% inflation on savings over 25 years, we find that prices will have increased by almost 65%. This means that in 25 years €164.06 would be needed to buy what could currently be bought for just €100.

Inflation Causes Uncertainty

The value of money is always in flux, making retirement planning especially difficult. This is complicated further by not knowing what the annual inflation rate will be.

Inflation- The Leaking Bucket

Over time, inflation has averaged more than 3%. Consequently, it has taken less than 22 years for prices to double. So, as you are saving, remember that it is like trying to fill a bucket while water is leaking out of tiny holes. You have to pour the water in faster than it leaks out.

What About Interest on Your Savings?

So far, we have only looked at savings that were hoarded. What if you deposit them in the bank? Won’t that help? If the interest rate is equal to inflation, then it would be like having a tap pour water back into your bucket at exactly the same rate as it was leaking out.

Alas, current bank interest rates are incredibly low, so there is barely any influx of cash going into banks from interests; meaning, the level in that metaphorical bucket has been declining almost as fast as physical piggy banks.

Gold & Silver

Some investments may not perform as well when inflation rates are high. For example, people often consider gold a safe investment during periods of inflation because its value does not go down in relation to other objects. However, over time commodities like gold and silver can become overvalued or undervalued.

While inflation has been historically low in the last 15 years, gold and silver have still outperformed its effects. However, that may not continue to be true. A major downside of commodity investing is that you don’t receive any current income from these assets–you are purely relying on their value increasing to keep up with inflation.

Property

Many Irish people invest in property, as it is thought to be a good way to keep up with inflation. However, this was not the case during the market crash, when values plummeted. So, like with everything else, it is important to buy at the right price point. Owning your own home does not produce income (although it may save you from paying rent), but investment properties can provide some protection against inflation and generate income at the same time.

What about stocks?

Ideally, the prices of companies would grow along with inflation so that the company’s value is maintained. But when you invest in stocks, other factors come into play including stock speculation (boom and bust), the ability of management to adapt to change, changing market demand for the company’s products, etc.

Many times, stocks will increase at a higher rate than inflation, letting your investment retain its purchasing power. Although it’s still possible to buy during a peak and then see the value dip shortly after or for your investment to grow more slowly than the market as a whole, some shares also pay dividends on top of the possibility for share price growth. Dividends from shares act similarly to interest payments, filling up your “bucket” while in theory, the share prices themselves should rise along with inflation.

Other Factors

Taxes can also play a role in the real return you experience, after accounting for inflation. In our first example, if the money had been hidden under a mattress, taxes would not have been levied against it because €100 is considered after-tax income. But since there was no other income generated, taxes were not a factor.

If you had your money in the bank during this scenario, taxes would be small because interest rates are tiny and so the money didn’t make much, meaning there’s not much tax due. However, if inflation was 2% but your savings account only paid 2%, then you would technically still be losing out because you’d have to pay taxes on that measly 2%. So basically, with a regular inflation rate of only 2%, you may need to earn 3% interest just break even–and that’s including taxation.

When you get taxed on your interest, it’s as if some of the money that would have gone into your savings is being redirected away, so it never has a chance to enter the bucket. To minimize risk (hedging) and increase chances of success, use diversification in your saving strategy. For example, if most of your saved funds are in cash equivalents like deposit accounts or savings accounts., these can be used for immediate expenses that aren’t prone to much inflation.

Using a mix of savings methods is the best way to protect your money against inflation and market uncertainty. Commodities like gold and silver, as well as real estate, will keep up with inflation better over time but won’t generate any income in the meantime. Shares in companies may provide some dividends along with maintaining their value against inflation, but they are also unpredictable. Therefore, using a combination of these strategies is the smartest way to ensuring you don’t lose purchasing power due to market fluctuations or price increases.

Advice

You should save and invest based on your unique circumstances by customizing a plan that works just for you. This way, you’re not putting all your eggs in one basket. And always get professional advice before making any final decisions. The institution you’re currently working with may not have the best solution for you, but a financial advisor will be able to offer unbiased suggestions from different places.

There are two different aspects to consider when planning your savings:

1. Your time horizon

– How long do you have to save?

2. The return on your investment

– What level of risk are you comfortable with?

By taking these two factors into account, you can develop the best strategy for investing your savings so that it will maintain its value against inflation. It’s difficult saving money, but it’ll be worth it when you have peace of mind knowing that your nest egg is safe from inflation. Talk to a financial advisor today about how to start safeguarding your wealth against inflation and begin seeing results soon.

If you would like to get more details, please give us a call.

The following is for informational purposes only and doesn’t qualify as financial advice, but we advise that you speak with us before making any decisions related to finance. A comprehensive approach is ideal for financial planning and we’re confident we can assist you in putting your plans into action.