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By: Tim Bennett
24.04.2020
24.04.2020
Even when inflation is at low levels, investors often underestimate its impact on their wealth as Tim explains in his latest video.
Background
With inflation at historically low levels, it is tempting to ignore its effect as a saver or investor. After all, assessing returns is quite a lot easier if you simply pretend it doesn’t matter and focus on what are called “nominal” (pre-inflation) returns. Here’s a reminder about why this is a mistake.
Why this matters
The problem is that, whilst inflation is low in annual terms, over time its impact on your returns compounds and can become much more significant over longer timeframes.
Why we often ignore inflation
Nonetheless it is often more convenient to sidestep the issue and many investors do, usually for three reasons;
Lower for longer
A quick look at the following chart reveals how far inflation has fallen over time;
However, another glance back towards the left-hand side reveals the potential problem here, namely that inflation has been much higher in the past and right now we may be sowing the seeds for its return.
The anchoring effect
The next problem is our preference for what are called nominal (not inflation-adjusted) numbers. An example will help to illustrate this.
Faced with who they would rather be, many people answer “Tim”. That’s because his headline pay rise – the number people tend to anchor to in negotiations – is higher. Yet, it makes more sense to be Tom in inflation-adjusted (“real”) terms.
The hidden long-term impact
The final challenge with inflation is that none of us is very good at thinking long-term. That means we tend to underestimate the impact inflation will have on our returns. The rule of 72 is useful here – an inflation rate of 4% will halve our buying power in around 18 years (72/4). Yet 4% doesn’t sound too painful in any single year.
Conclusions
In short, it may be easier to ignore inflation as an investor, but it may not be advisable.
Conclusions
In short, it may be easier to ignore inflation as an investor, but it may not be advisable..
If you would like to discuss the potential impact of inflation on your portfolio and ways that you may be able to mitigate it, please contact an Adviser or email me at [email protected].
