Money is only useful if you can exchange it for things you need or want. When you’re investing it, what you’re really trying to do is maintain (or hopefully grow) its purchasing power.
Working against you in the background is inflation. As prices rise, each dollar doesn’t go quite as far as it did before, so you need to make sure your capital grows by at least the rate of inflation just to stand still.
Let’s say you’re signing up for a one-year term deposit today, for which my bank is advertising a rate of 5.7 per cent.
That’s the nominal return you’ll get, and it looks good on the face of it. The real return (which is adjusted for inflation), on the other hand, could be quite a bit less.
The latest Reserve Bank projections suggest inflation of 4.2 per cent over the coming 12 months. That means the “real” return from that term deposit won’t be 5.7 per cent, but a much less exciting 1.5 per cent.
Don’t forget you’ve got to pay tax on that income too, so at a personal tax rate of 30 per cent, the headline 5.7 return falls to 4.0 per cent. Take the 4.2 per cent inflation rate off that, and the real return is now slightly in negative territory.
It’s tough, isn’t it? The best deposit rates in 15 years and savers are still going backwards.
It’s important investors understand the impact inflation can have on their savings and the difference between nominal and real returns.
Mark Lister is investment director at Craigs Investment Partners. Photo / Supplied
Those who remember the 1970s and 1980s will appreciate this, as inflation averaged 11.7 per cent over those two decades.
The 1970s was a particularly difficult decade for investors. Shares, cash and bonds all failed to keep pace with inflation, while house prices only just held their own. The only good investments were commodities and farmland.
In contrast, from 1990 until 2020 the New Zealand inflation rate has averaged just 2 per cent annually. Those of us under 50 haven’t seen high inflation in our adult lives, so the concept of real returns hasn’t been as important.
However, even at low levels, inflation can do a lot of damage to your wealth. At 3 per cent, it will still reduce your purchasing power (and the value of your capital) by more than 25 per cent over 10 years.
Over the past 50 years, New Zealand’s annual inflation has averaged 5.6 per cent, dragged higher by the 1970s and 1980s.
New Zealand shares have returned 9.6 per cent over that period, while house prices have increased 8.8 per cent, both beating inflation comfortably and delivering positive real returns.
Cash and deposits are a safe option for your money over short timeframes, as they won’t fall in value the way shares, houses and even bonds have in recent years.
They might be a good place to be for a little longer yet, just don’t get too comfortable or stay too long.
Over any longer horizon, it’s crucial to have exposure to assets that will deliver positive real returns by growing more than the inflation rate.
Mark Lister is the investment director at Craigs Investment Partners. The information in this article is provided for information only, is intended to be general in nature, and does not take into account your financial situation, objectives, goals, or risk tolerance. Before making any investment decision Craigs Investment Partners recommends you contact an investment adviser.
