How Inflation Eats Up Your Investments

High energy prices and pressure on key resources have sparked increases in cost of all essential items. Whenever prices start to rise, people often worry about inflation and with a good reason too. With rising inflation rate, you will find that your purchasing power has shrunk, now that you have to pay more to get less. Ever heard that a ringgit does not go on as far as it used to be?

For those of you who are still young, at least you know that over time, the increases in your income should catch up with the inflation and would essentially still be able to add on to your savings. However, for those of you who are closer to retirement or are already in retirement, this is a bigger concern as inflation will erode the savings or investment that you have prepared for your retirement.

What is Inflation?
In economic terms, inflation is the increase in price of a basket of goods and services, which are representative of the country’s overall economy. The index that measures the inflation rate is Consumer Price Index (CPI). Our year-on-year inflation rate has soared to 8.5% in July and this is the highest since December 1981. According to the latest Government’s forecast on the inflation rate from the recent Budget 2009, our inflation rate is expected to be at 4.4% for the whole of 2008.

How does inflation affect your investment?
We have established that inflation will make your money shrink. Assuming that your investment portfolio consists of stocks, fixed-rate bond, real estate and cash, what effect would inflation have on each of these investments?

(i) Stocks
When there is a hike in the inflation rate, stock prices will react negatively to such a hike at the initial stage. This is particularly so for businesses that are unable to pass on the negative impact of inflation to consumers and as such are left with no choice but to anticipate that their profit margin will suffer. However, over a longer term, stocks are still a good hedge against inflation as companies earnings tend to increase with inflation. The key is to choose the right stocks to invest in, namely those that benefit from inflation. You can choose to invest in companies that are involved in storable commodities. Energy and metal would be good examples as they are linked to economic activities or large-cap companies, which have strong cash positions and the ability to withstand the inflationary pressure.

(ii) Fixed-rate bond
If you have invested a substantial amount in fixed-rate bond, increasing inflation is definitely bad news to you. As you will be receiving fixed interest payment into the future, higher inflation means the future value of the periodic fixed income and the principal that you are going to receive will get smaller. If interest rate increases as a result of higher inflation, which usually happens to cool down over-heated economic situations, the price of the outstanding bond that you are holding will drop as it gets less attractive compared to the newly issued bonds that will have higher rates. Therefore, at the peak of inflation, when the interest rates are pushed up high, that is the time when you can consider investing some in bonds.

However, if you look at our current situation, you will notice that even though our inflation rate has spiked to an all time high, the interest rate still remains the same. This is because the current inflation hike is due to cost-push effect and not demand-pull effect, which means that the inflation increase is mainly due to increase in cost of goods and services resulting from the oil price increase rather than due to increase in demand. Under the circumstances, we should adopt the approach of ‘wait and see’ until things get more stabilised.

(iii) Real estate
Over the long run, investing in real estate has proven to be a good hedge against inflation. However, invest directly in real property requires huge sum of money and long holding time, apart from the other risk factors involved. With REIT (real estate investment trust), which consists of a pool of commercial property and apartment buildings, it provides an alternative for you to invest indirectly in real estate, thus enabling you to enjoy the benefits of investing in real estate at a much lower risk of risk.

(iv) Cash
Logically, this should be the worst hit category compared to others mentioned above. If you keep your cash in a 12-month fixed deposit rate of 3.7%, with inflation rate of 4.4% (based on the Budget 2009), your real return will be negative 0.7%. In short-term, it is acceptable to get negative returns in view of the uncertainties of returns in most investment products that are available in the market.

Putting all the above together, you will see that an ideal investment portfolio should be diversified to address various needs. For growth, you need to invest part of your portfolio in asset classes that participate in economic growth, which are namely stocks and real estate. Over a long term period, stocks provide good hedge against inflation. For predictable cash flow, fixed-income securities should serve the purpose. Finally, even though you should not keep most of your money in the form of cash, you will still need to keep a minimal amount of cash, which is equivalent to about your 6 months living expenses for emergency use. Most importantly, never put all your eggs in one basket!



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This article was written by SIDC and Mr Ooi Kok Hwa, a holder of a Capital Markets Services Representative’s Licence to carry on the business of investment advice under the Capital Markets and Services Act 2007. The information provided in this article is for educational purposes only and should not be used as a substitute for legal or other professional advice.