When designing a retirement portfolio one of the biggest issues investors worry about is the effect of inflation. Specifically, mum and dad investors try to ensure that the capital value of their portfolio and the income produced by it will keep up with inflation.
A feature of the post-2008 crisis landscape has been the printing of money in America and many investors are worried that this will mean inflation down the track.
The retired clients of financial advisers and stockbrokers still have vivid memories of the high inflation sparked by the policies of the Muldoon government in the 1970s and 1980s and this tends to affect their investment behaviour. So when a financial adviser tells them that shares beat inflation, this is music to their ears.
However, it is not that simple. If you bought a portfolio of international shares on January 31, 2000, you reinvested the dividends and didn't pay any tax, the value of your investment today in New Zealand dollar terms would be 26 per cent less than what you paid.
Inflation in that period in New Zealand has totalled 38 per cent, so that not only have international shares not kept up with inflation, the real value of an international share portfolio is down by more than 60 per cent.
Ouch - so much for shares beating inflation over the long term.
And if you think that's bad, consider the plight of the poor Italian share investor. In the 1900s to 2011 period, there was a massive 74-year interval when shares underperformed inflation.
The truth is that you need to own shares for a long, long time to be confident that they will beat inflation. What's more, given the present preoccupation with inflation, a contrarian might bet that deflation, not inflation, was around the corner.
This is all a bit confusing, but factual information and sensible advice is available. The feature article in this year's Global Investment Returns Yearbook (GIRY) looks at the incidence of inflation and deflation from 1900 to 2011 and then evaluates which asset classes have historically been best able to cope with each of these scenarios.
The GIRY is produced for the Credit Suisse Research Institute by three London Business School professors, Elroy Dimson, Mike Staunton and Paul Marsh.
They are the global authority on long-run investment returns and their database spans 21 countries, with the performance of stocks, bonds, bills, inflation and currency for most countries back to 1900.
The yearbook is full of interesting information and, if long-term returns are your thing, it doesn't get much better than this.
According to the GIRY, New Zealand's inflation in the 112 years since 1900 has averaged 3.7 per cent a year. This is higher than the US at 3.0 per cent but a bit lower than Australia at 3.8 per cent and a lot better than Germany and Japan at 4.8 per cent and 6.9 per cent respectively.
Of the 21 countries in the GIRY, Italy comes out worst over the long term, with an average inflation rate of 8.4 per cent.
I had always thought that New Zealand's high interest rates relative to those of the US, UK and other Western countries had been due to our higher inflation, but at 0.7 per cent a year since 1900, we haven't done that much worse than America and better than the UK at 4 per cent a year.
So why are our 10-year bonds yielding 4 per cent and American 10-year bonds yielding 2 per cent? It may be that as we rely on overseas savings so much, many of the holders of New Zealand government bonds overseas have a currency risk to worry about as well, so require a high yield to compensate.
Switzerland has the lowest inflation over the 112 years in the GIRY sample, averaging 2.3 per cent a year, and of all the countries where long-term data is available, the average inflation rate was 5.3 per cent a year.
It is interesting to see the extremes that the GIRY highlights: inflation hit 361 per cent in Japan in 1946 and 344 per cent in Italy in 1944. But the Germans can always be relied upon to go one better: annual inflation there reached 209 billion per cent in 1923 and 30,000 per cent in October of that year alone.
Needless to say, the GIRY figures for Germany exclude the data from 1922 to 1923 as their inclusion would make the average a bit meaningless. Germany's hyper-inflationary period was an interesting one from an investment perspective, and was covered in this column a few years back. But the lessons bear repeating.
The hyper-inflation meant that the risk return profiles of many asset classes were reversed - what was low-risk became high-risk and investors lost everything; what was high-risk protected the owners' wealth.
For example, the average German with money in the bank lost everything - the bank deposit was repaid but hyper-inflation made the money worthless. In contrast, investors who owned shares, property, gold or overseas assets were okay because the prices of these assets moved up with inflation.
Germany is being criticised today for making Greece promise to balance its budget - the background is that it still remembers the damage done to its own country and the rest of the world during the 1922-23 period.
Another way of appreciating the impact of inflation is to consider how much US$1 in 1900 would buy today. The GIRY estimates that a 1900 greenback would buy the same amount of goods and services as $26.30 today, or looked at another way, today's US$1 is worth US3.8c in 1900 money.
Inflation has been an insidious destroyer of wealth, particularly in the second half of the last century, so it is no wonder that investors with a longer-term horizon are always looking for some way of protecting their income and assets from its impact.
But prices don't always rise - sometimes they fall, and this is known as deflation. While some investors are worried about inflation, others argue that the global economic environment is worse than anything the developed world has seen since the 1930s and fear that an extended recession might lead to depression and deflation.
Deflation is regarded more seriously than inflation as it is generally accepted that deflation is much harder to stop. The effect of deflation in the US in the depression was such that the price level fell from 2.6 at the end of 1920 to 1.78 in 1933 and it was 1947 before prices returned to the end-of-1920 level.
But was this 1920s deflation an anomaly? Not according to the long-term historical record, which shows that over multiple centuries it is normal to have inflationary periods alternating with deflation.
According to the GIRY, since 1900 every country has experienced deflationary or near-deflationary conditions an average of one year in four and Japan has had deflationary conditions for 25 years.
Some experts argue because central banks like the US Federal Reserve are so worried about deflation, they will do anything to prevent it. Federal Reserve chairman Ben Bernanke once said if things got really bad, the Fed was prepared to drop US$100 bills from helicopters to get things going.
Nothing is certain in this world, so given that the implications of deflation are so bad and the fact that the Japanese haven't been able to escape its clutches, all investors need to be aware of it and include in their portfolio assets that can cope with it.
In two weeks, with the help of the Global Investment Returns Yearbook, we will look at how well various asset classes have performed in times of inflation and deflation.
Brent Sheather is an Auckland-based authorised financial adviser. His adviser/disclosure statement is available on request and free of charge.