Inflation is one of the key factors that affect the direction of your investments as they go to the core of the returns you earn on your investments. Inflation being the rate of depreciation of a currency leads to an increase in the prices of goods and services. Headline inflation released by Government through the Statistical Service provides a limited degree of its application in our daily lives. The convoluted relationship between inflation and investment returns must be understood in order to harness the full potential of our investment portfolio.
Inflation single-handedly has the highest impact on investment returns. The inflation rate gives an indication of the rate at which the purchasing power of our hard-earned money is being eroded. In effect, we will need to increase our spending in the future just to maintain our current standard of living. The inflation rate should therefore be the basic or minimum rate that any investment portfolio should return.
If we earn returns on our investment portfolio that is equal to the prevailing inflation rate, we will be in the position to maintain our current standard of living. On the other hand, if our investment returns are higher than the prevailing inflation rate, the purchasing power of our money will be higher and we will be in the position to spend less just to maintain our current standard of living. In order to fully appreciate the impact of inflation on our investment returns, we need to reorient our minds on how we interpret the headline inflation.
For example, using the current headline inflation of 27.6% to interpret the effects on your investment returns would simply not paint the full picture. Headline inflation is just the aggregate of the essential expenses like food, transportation, utilities etc. That being said, the expenditure of an average person goes beyond the items constituting the inflation basket and these items are not captured by the headline inflation. Some of these include healthcare, phone bills, tv subscriptions, holidays and many more. Inflation increases as the variety and quantum of expenses increase.
This means the actual inflation rate that applies in reality to our lives is higher than the headline inflation that is released monthly by the Ghana Statistical Service. The minimum inflation that one needs to use in terms of reviewing their purchasing power should be about 2 to 5 percent above the headline inflation. In this instance, it should range between 29.6 percent and 32.6 percent. the benchmark for inflation needs to be revised when changes occur in the headline inflation. In addition to this, because inflation of various line items in the inflation basket is not the same, each financial goal must be accompanied by its inflation target. Assuming you set up an investment portfolio for a house, that investment return must be measured against housing inflation.
The returns of investments are in two concepts: either using nominal returns or real returns. The nominal return is the basic return that is generated by an investment portfolio whiles the Real return is when the nominal return is adjusted for taxes and inflation. Using the current inflation and 91-day treasury bill, the real return is shown below.
| Nominal return | = 24.09% |
| Tax rate | = 0% |
| Headline Inflation rate | = 27.60% |
| Real return | = ((1+post tax return)/ (1+inflation rate))-1 |
| = | ((1.2409)/ (1.276))-1 |
| = | -0.0275 |
| = | – 2.75% |
The real returns give us a clear indication of how your purchasing power will change over time. The real returns as the name suggests are the most realistic benchmark by which your investment returns should be measured and not the nominal return. When your real return is 0% and above, it is acceptable but a negative real return reduces your purchasing power. The demonstration above gives the true reflection of your investment performance and will show how relevant the returns are to you in the real world.
A careful look at a number of the investments out there will show you that though their nominal returns look attractive, they are actually posting negative real returns.
The writer is an investment analyst. He can be contacted on [email protected]
