The next twelve months are shaping up to be a big squeeze for
investors. We have been through a period where real interest rates,
(that is, the rate of return on your money less the rate of inflation)
have been positive. Leaving your money in the bank has allowed you to
keep ahead of inflation and grow the value of the money invested.
However, the environment is changing and investors’ real returns are
being squeezed by increasing inflation and falling interest rates…
The Consumers’ Price Index increased by 4% in the year to June, 2008 but in the June quarter alone, it increased by 1.6%; the equivalent of 6.4% over a year. This is the highest quarterly increase since 1990.
The Reserve Bank has a target of keeping inflation within a range of 1-3% and until recently it has done a reasonable job of keeping within this target range. Low levels of inflation combined with high levels of employment have given us a comfortable economic environment; so comfortable that we’ve almost forgotten about how much damage high levels of inflation can inflict on our purchasing power.
For those with an eye for detail, there is a handy little inflation calculator on the Reserve Bank website. Just go to www.rbnz.govt.nz and click on the link to CPI Inflation Calculator. Using this calculator shows that a basket of goods and services that cost $100 in 1988 now costs $165, reflecting an average compound inflation rate of 2.5% a year over that twenty year period. Go back to the twenty year period from 1968 to 1988 however, and you find that a $100 basket of goods and services would have risen in price from $100 to $896, reflecting an average compound inflation rate of 11.6% a year. Those were the days when mortgage interest rates were 15-20% and house prices were increasing by over 20% a year. We’ve forgotten what those days were like. We’ve become complacent about inflation.
While inflation is increasing, interest rates are heading down. Whereas you might get up to 7.5% in the bank on a term deposit now, this time next year rates could fall by 1%. By the time you deduct income tax and allow for inflation of 5%, your capital will be losing its purchasing power and any interest income you spend will further reduce the value of your capital.
Many investors have a strategy of putting all their eggs into the one asset class which is at the top of its cycle. Over the last ten years they have leapt from shares to property and finance companies and now bank deposits. The problem is that by definition the top of the cycle signals a market decline and these investors have simply lurched from one crisis to another. If instead they had spread their funds over a combination of shares, property, fixed interest and cash, they would have ridden through the ups and downs and would be poised for growth as share markets rebound. It’s quite simple, really. If you don’t want to get squeezed, diversify.