Ahad, Februari 13, 2011

Money: Hedging against inflation

2011/02/12 Yap Ming Hui

WHAT is inflation? In the economic field, it is defined as persistent and consistent increase in general prices over a period of time.
In layman’s term, it means the prices of goods and services go up and never come down.

Based on the Government’s statistics, our Consumer Price Index (CPI) is about two per cent. But most of us experience a higher inflation rate as we consume a lot of items that are not counted in the CPI.

Two weeks before Chinese New Year, I met someone in a kopitiam who told me the coffee that used to cost RM1 a cup three years ago was now RM1.30. That’s 30 per cent increase in three years, which is equivalent to 10 per cent per annum.

Though not every item has a price increase of 10 per annum, I personally estimate the inflation rate to be about four to six per cent.

Case study
Michael is 50 years old. He used to own and manage a successful chemical material distribution company.
Last year, he sold his company to a multi-national for RM3 million and retired.
Due to previous bad experiences in stock market investments, he decided to put all his money into fixed deposits instead and earn the interest. He believes he can live on the interest alone and eventually, leave the principal sum of RM3 million to his children when he dies.
Based on his calculation, the interest he will get should be about RM120,000 (RM3 million x four per cent annual interest rate).
Therefore, he believes he can maintain his living standards with RM120,000 per year for as long as he wants.
Do you agree with his plan? Is there any problem with it?

The problem
Michael’s retirement plan is a typical example of how one manages money without considering the impact of inflation. In Michael’s plan, inflation is non-existent. He presumes that the RM120,000 generated by his fixed deposit interest will continue to be worth RM120,000 in 10 years time. He also presumes that his RM3 million will continue to be worth the same 10 years later.
Here’s a very simple example to illustrate the impact of inflation, using a six per cent average increase in the cost of living (inflation) and four per cent annual investment return.

Let’s look at the middle column first. Note that if we start with a capital of RM3m and an average six per cent inflation, it takes only 12 years for the capital sum to decline by 50 per cent. In other words, if you took RM3m, buried it in your garden and dug it up 12 years later — assuming the average inflation rate of six per cent during the 12 years — your money would be worth only half as much as when you buried it.

And every 12 years thereafter, its value would further reduce in half.
So here is the first negative impact of inflation — it destroys capital.
If Michael dies at 86, he will leave his children with a wealth worth of RM375,000 instead of RM3,000,000 that he has originally planned.

In money management, accumulating capital is only an intermediate step. The end game of this is to provide us income at some point in our lives.

Ultimately, we all want to replace our working income with investment income. The only difference is when we want to start receiving that income.

Some people want it right away (like Michael) because they are already retired.
Others won’t need it for 10, 20 or 30 years. So, if generating income from your investment is your ultimate goal, let’s look at the impact of six per cent inflation to your investment income over time (third column).

In Michael’s example, a four per cent return on RM3,000,000 will yield RM120,000 annually. But at a six per cent inflation rate, the purchasing power of that income in 12 years will buy only half of what it can today.

In other words, if you can buy a cup of coffee at RM1.30 today, it will cost you RM2.60 12 years later.

By the time Michael reaches 74, the purchasing power would be cut in half once more. If Michael lives to age 86, he will need to get by on one-eight of the purchasing power with which he had retired.

Inflation is a serious problem and although its severity goes up and down, it never disappears completely.

In fact, in the long run, loss of purchasing power is the greatest investment risk we face.

Effective solutions
1. Understand the impact of inflation. Change your paradigm. Recognise inflation and understand the damage it can do to your created wealth.

2. Cut down expenses and spending. Plan your shopping and buy only what you need. If possible, time your purchases. Buy more items at sales. You will enjoy easily 20 to 50 per cent saving. To further cut down your expenses, eat at home. That will save you another few hundred ringgit every month.

3. Minimise your cash holding. Your money is shrinking in the bank every day. If inflation is at six per cent and your bank interest rate is four per cent, your actual investment return is -2 per cent per year. So, I would suggest that you hold cash only for emergency purpose. If you are working, hold emergency cash equivalent to six months of living expenses. If you are retired, hold emergency cash equivalent to three years of living expenses.

4. Invest the extra cash to hedge against inflation. Once you have set aside your emergency cash, you can afford to invest the rest in longer-term investments that will hedge against inflation such as:

• Equities: Effectively-run businesses normally can pass whatever price increases to their customers. As a result, profits will increase and share prices will grow accordingly in the long run.

• Property: The price of properties will also grow due to the rising land prices and rising building material prices. Investing extra cash on selected properties will help you to hedge against inflation and make some extra investment return.

• Unit trust: If you are a new investor with a small cash outlay, unit trust investment may be right for you. But not every unit trust fund can effectively ride on inflation. Therefore, choose equities funds only or at least balanced funds. Avoid fixed income or money market funds because they may not outgrow the inflation rate in the long run.

2bz4money:  I've succesfully followed this advise..

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