Sunday 27 April 2014

Inflation – The Silent Killer

At the end of every year, I will compute the gains and losses on my investments. As part of the exercise, I will also compute the real gains or losses after inflation. Being human, I tend to focus on the larger nominal gains rather than the smaller real gains. However, the real gains after inflation does have an important story to tell. After reading "Beating the Street" by Peter Lynch, I decided to look further into the effects of inflation on my investment gains and investment policies.

In the 15 years of investing with my own money since 1998, the inflation rates have been as follows:

Year Inflation
1999 0.0%
2000 1.3%
2001 1.0%
2002 -0.4%
2003 0.5%
2004 1.7%
2005 0.5%
2006 1.0%
2007 2.1%
2008 6.6%
2009 0.6%
2010 2.8%
2011 5.2%
2012 4.6%
2013 2.4%
Average 2.0%

Over the 15-year period, the average annual inflation was 2.0%, which looks quite reasonable and in line with expectations of 2% to 3% based on historical inflation. Yet, guess what is the cumulative losses to inflation over the 15-year period? It is a staggering $218K!

It is interesting to compare the losses to inflation to the losses in investment at the depth of the Global Financial Crisis. Then, the investment losses were estimated to be around $175K out of an invested capital of $270K invested in shares, Real Estate Investment Trusts and Business Trusts. This worked out to be a loss of 65%. This was a very painful loss, yet, in terms of magnitude, it is actually smaller than the cumulative losses to inflation. A 2% annual inflation over a 15-year period can actually result in a larger loss than a one-time 65% drop in share prices during a severe market crash! The reason why inflation is a bigger monster than market crashes is because inflation affects the entire capital base every year whereas market crashes only affect the portion of the capital invested and only for the duration of the market crash.

Many people have been fearful of losing money in investments, which can be difficult to recoup. Personally, I have also kept a significant portion of my capital in cash yielding next to zero interest rates so that there is capital available for investing at the depth of the next market crash. Yet, oblivious to us, inflation is slowly but surely eroding our capital to a similar extent as the very market crash that we are trying to avoid.

Emotionally, it is a lot easier to cope with a 2% annual inflation than a one-time 65% drop in share prices. With inflation, the amount of our capital does not reduce, only the value of it gets smaller. With investment losses, the amount of our capital reduces. Yet, the net effect is much the same in both cases. We are like the frog which immediately jumps out of boiling water but does nothing when the temperature of the water is slowly raised.

It should be highlighted that losses to inflation and investments are not mutually exclusive. It is possible to lose $200K to inflation and another $200K to investments. Whether you invest or not, the losses to inflation are guaranteed. If you invest, at least you have an opportunity to recoup the losses to inflation and maybe make a little more.

It also does not mean that you have to be 100% invested to guard against inflation losses. Past experience in market crashes have shown me the importance of having cash or cash-like instruments to recover from the severe market losses. I will still keep cash on hand, but perhaps not to such a significant portion. For my portfolios that are 100% invested, a portion is kept in bonds to be rebalanced into equities during a market crash.

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  1. Did you measure your investment portfolio gain using either CAGR or XIRR over the last 15 years?

    1. No, I didn't use CAGR or XIRR as I didn't have a separate bank account for my investment cashflows.

      I've also been following your blog and note that you also keep cash in preparation for the next market crash. What's your experience with inflation and your views on this strategy?

    2. We may have little choice but to spend some effort and time to learn more on investing and to manage our investment portfolio to beat inflation by some percentage unless we are successful in climbing corporate ladder. The promotional salary increments and annual bonuses will be way ahead of inflation.

      Two ways to beat inflation:

      1) Do well in our career development and climb corporate ladder

      2) Do well in our investment and climb investment ladder