How to beat inflation

How to beat inflation
27 March 2012

THE price of most things tends to go up as time passes – what we know as inflation. This makes our money lose its worth bit by bit as time goes by.

This is not an abstract concept; it’s a real phenomenon that affects us all, so we should understand what it is, how it impacts us and what can we do to protect ourselves from it.

On the average, our money loses 5% of its value every year. So if you keep $100 in your piggy bank for a year, by the time you take it out it would only be worth $95. Sure, it’s still $100, but because prices of goods and services have risen the buying power of your $100 has been diminished.

Cash is a losing game

This is why it’s not a good idea to keep your money idle for too long without earning something. For example, if you had your money saved with a bank, it would probably earn a meagre 1% interest per year; that means you still lose around 4% of its value in a year.

Of course, keeping money in the bank has its use. It’s where you park cash for easy access – for everyday expenses as well as life’s little emergencies.

However, if you have more money in the bank than you will need in the near future, you are putting yourself at a disadvantage.

Invest to beat inflation

Assuming you can’t get a positive real return from a bank account and ignoring the opportunities to beat inflation by starting your own business or providing seed capital, your only viable option is to invest in ‘real assets’ in the form of shares, bonds, property and alternatives (such as syndicated private equity and hedge funds).

Different real assets offer vastly differing returns, but for each unit of extra return you generally have to accept more risk in the form of volatility. It is this volatility and the potential for losses that frequently stop people from investing and, therefore, effectively accept that they are going to lose money each and every year.

Build and preserve your wealth

It doesn’t have to be that way. Prudent investment management is possibly the most important contributor to building and preserving wealth. Here’s how to do it properly:

1. Risk profiling

The first step towards successful investing is to assess your risk profile. This process is divided into two parts: analysis of your ability to take risks (based on your financial position and objectives) and analysis of your attitude towards risk (the level of risk you are comfortable with).

The outcome of this process will help you to identify the right asset mix for you – the one that maximises your exposure to high-returning assets, but without causing you sleepless nights.

2. Asset allocation

Having first agreed your attitude to risk and reward, the next step is to put together a mix of assets that is matched to your risk profile and appropriate for the prevailing economic circumstances.

Despite the countless offerings dreamt up by investment companies’ marketing departments, there are basically four main types of assets available to investors: equities (stocks and shares), fixed interest (gilts and bonds), property and cash.

Each of these asset classes has different risk characteristics and relative attractiveness during different stages of the economic cycle. It is universally accepted that holding the right mix of assets at the right time is by far the biggest determinant of portfolio performance.

Of course, each of the main asset classes has many sub-divisions. Equities, for example, could include UK equities, European equities and US equities. These sub-divisions have further sub-divisions within them, such as UK large caps or European smaller companies.

3. Selecting investments

The next stage is to pick the best investments within each of these asset classes, and the best way to achieve this is through collective investments.

Fund managers run these funds, holding a diversified spread of investments to provide substantial risk diversification.

To achieve your target asset allocation of, say, 30% UK equities, you might typically invest in four collective funds at 7.5% each, therefore gaining further diversification and spreading of risk.

Pic credit: photostock/ FreeDigitalPhotos.net

Do you invest with inflation in mind? What's your top tip?

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Chartered financial planner
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