The time to think about how to stop inflation making you poorer is long before it strikes. You want to move before too many other people fear inflation, and so bid up the price of taking action.
Inflation is a key reason why equities are better for long-term investments. Cash and bonds may sometimes seem likely to yield a higher income at less risk, but historical returns show equities nearly always perform better over multiple decades, and so are a superior defense against the corrosive impact of inflation.
But what about if you want to take short-term evasive action to stop inflation from eroding your wealth – or to balance your portfolio in that direction?
Equities are just one option. Here are ten ways to beat inflation.
1. Higher interest
If you’re earning 2% on your cash savings and inflation is running at 3% on your chosen measure, then in real terms you’re losing 1% a year – even though your bank balance is going up.
This is because the spending power of your cash has declined in real terms. If it cost £1,000 to buy what you want one year, and next year it costs £1,030 due to inflation, then growth in your savings to £1,020 isn’t good enough.
You may need to lock away your money for a year or more to get a sufficiently high savings rate to beat inflation. Sometimes (such as the start of 2011) it may even be impossible, but such periods don’t usually last long.
2. Tax shelters
Carefully consider whether you’re best using the tax shield of ISAs to protect your cash savings or your equities.
You should certainly be doing one or the other. A 2% return on cash becomes a 1.6% return after tax is deducted, and just 1.2% if you’re a 40% rate payer.
These reductions make it even harder to beat inflation. Don’t suffer them unless you’ve used up all your shelters.
3. National Savings certificates
If you’re after simple inflation-proofing with a 100% government backed guarantee, then National Savings certificates are impossible to beat.
These certificates are basically bonds issued for the mass market by the UK Treasury, via its National Savings and Investments arm.
They come in three and five year flavors – though you can cash them in at any time – and they guarantee a real return above RPI inflation, usually in the order of 1% a year. Capping it all, the return is tax-free!
But the certificates have two drawbacks.
Firstly, you can only put put a certain amount of money into each issue – latterly £15,000 – and since there are only 1-2 issues a year, that severely limits how much you can stash away.
Secondly, as I write they have been withdrawn from sale since July 2010, because everybody wanted them so demand outstripped supply. You can sign up at the NS&I website to be alerted should that change.
4. Index-linked bonds
Both governments and companies issue bonds that offer inflation-proofing that’s superficially similar to National Savings certificates, in that there’s an adjustment for inflation, plus some sort of return on top.
In practice there are a lot of differences. The most crucial one is that these bonds are traded in the market, and so the price will fluctuate as the outlook for inflation changes. Unless you buy them when they’re first issued and are prepared to hold them until they mature – which will be many years away – then you could lose money.
This price oscillation means too you’re not guaranteed to get inflation protection, if the market has judged it wrong and so priced the gilts incorrectly.
I can’t even begin to cover the complexity of these vehicles in a short summary:
- Try Fixed Income Investor for more on index-linked gilts.
- Learn more about index-linked corporate bonds (where you also face the risk of a company defaulting).
- Read up about the relatively new index-linked corporate bond funds such as M&G’s. (That’s not a specific recommendation, by the way.)
Another option are certain ‘step-up’ securities issued by banks and building societies (in the latter case as PIBS), which have the ability to reset to a premium over base rates if they’re not called by the issuer beforehand.
Even that sentence would take a whole new post to explain, but if you’re a sophisticated investor who understands the risks, you might want to investigate them further. Fixed Income Investor covered a couple recently.
5. Special inflation-linked ‘savings bonds’ from banks
Banks and building societies are starting to offer savings products tied to the inflation rate. It’s clever thinking on their part, as the demand is likely to be huge.
For instance, as I write Birmingham Midshires is offering a five-year inflation bond paying 0.25% above the RPI inflation rate as it stands every January. A further benefit is that unlike with index-linked gilts (but as with NS&I certificates) your original investment cannot go down in value. The catch is you have to lock your money away for five years – there’s no early withdrawal.
I think we’ll see more of these in the next few months, especially if NS&I leaves its shutters closed, so keep your eyes peeled if you’ve got cash that you want to safely tuck away for years.
6. Buy property and other real assets
Property is a so-called ‘real’ asset; it is a tangible good that does something useful, that you can see, touch, and use.
That’s in stark contrast to the opposite, a ‘nominal’ asset, like a pillowcase stuffed full of banknotes, or a bond that pays a fixed income.
If inflation takes off, an owner of property will typically be able to increase the cost of using that property –a landlord will increase rents, while a residential owner will judge that the next house buyer will pay more to ‘consume’ the accommodation provided by the property. Both will jack the purchase price up!
Remember, our renter will typically be able to pay the higher rent, because her salary will have gone up too, due to inflation. (Unless the renter is a poor pensioner relying on a fixed annuity, of course. You see why the old rightly fear inflation?)
Real assets are preferable to nominal assets in inflationary times, provided they retain their pricing power. But don’t expect the inflation-protection to come in on the nose like with RPI-linked certificates.
Real assets are illiquid, and the pricing is often opaque, so the moves will be jumpy. But in the long-run, many things that are useful, tangible, rare and/or precious can keep their value through inflation (assuming the State itself holds up – think 1970s Britain, not 1920s Germany!)
7. Get into debt
Inflation is great if you’re in debt.
Anyone of limited means who tells you that buying a property with a huge mortgage is trivially easy almost certainly bought in the 1960s, ’70s, or early ’80s. During much of this period, inflation eroded the real value of their debt.
A £100,000 mortgage will halve in value in just 14 years to barely £50,000 in real terms if inflation is running at 5%.
True, interest rates will likely rise to combat the inflation, increasing the monthly cost of repaying the mortgage. The important number to watch is the real interest rate, which is the interest rate you’re paying minus the rate of inflation.
As I write, you can take out a fixed-rate mortgage charging under 4%. CPI inflation is running at 4%, and RPI inflation is over 5%. The net result is that anyone with a 4% mortgage is paying a zero or even negative real interest rate – they’re potentially making a profit by being in debt!
8. Buy equities
Equities are a far better bet against inflation than cash or bonds. I don’t say a perfect bet, and I don’t say over all time periods, but the fact is that over the long-term, total returns from equities have run far ahead of inflation in most developed markets.
This shouldn’t surprise us: The stock market represents a traded chunk of the real economy, and ultimately the economy is where the inflation happens.
To give just one example, if the average basket of groceries goes up in price by 5%, then all things being equal Tesco’s turnover and profits will eventually go up by 5%, too.
Now, there may be time delays. It may be that fuel costs hit first and price rises have to be implemented gradually – all sorts of things can happen that means your shares won’t go up lockstep with inflation. And in hyper-inflationary times, you’re probably better off with a shotgun or a passport. Otherwise, equities should make up the bulk of most long-term savings, in my view.
Note: Reinvesting dividends received is the key to inflation proofing via equities. Share price rises alone have matched inflation over the very long term, but they can lag for decades.
Occasionally you’ll see articles arguing that bonds offer superior protection than equities over some periods.
This will certainly be true sometimes, simply because equities are volatile. If shares plummet 40% in a year then, guess what, you weren’t protected from 5% price rises!
Otherwise, I’d guess that most of the time it only happens when bond yields start very high – not like now when you’re still getting less than 4% on 10-year gilts.
Anyway, you can also find analysts arguing that short-term inflation cycles are good for stocks. I suggest eschewing the data and using common sense.
There’s a lot of debate about whether gold is a great inflation hedge or not.
I find it ironic, for instance, that the same gold bulls who tout its virtues as protection against rising prices also point to the fact that in real terms gold is still far below its early 1980’s peak as an argument against it being too pricey.
Hm, so gold hasn’t done such a good job protection against inflation over the past three decades then, has it?
Gold enthusiasts will also tell you that over the very long-term, an ounce of gold buys about the same amount of goods and services as it did in 1850-wotsit, or that it’s worth the same as a good man’s suit, or that it reverts to some ratio to the Dow Jones Industrial Average.
I’m not sure if any of this is helpful, but there’s no doubt that as a coveted real asset, gold has the ability to escalate in price when inflation strikes. As such, it’s not going to hurt to hold some gold in inflationary times.
But as I said at the start, you ideally want to buy your inflation protection before most other people do. I can only leave it to you to decide whether that’s true of gold, after a more than five-fold advance in a decade of generally low inflation.
10. Game the system
Not everything in the baskets of goods that make up the CPI/RPI statistics is rising in price. Some goods and services are shooting up, but others are seeing price falls.
If you tilt your spending towards the stuff that is going down in price or where prices are static, then inflation isn’t as big a deal for you, especially if it proves temporary.
For instance, there’s a good chance the price of imported goods will become cheaper in a year or two, since the pound still seems to be trading at historically depressed levels to me. Defer your spending for a year or two, and you might buy the same things cheaper.
Who knows, perhaps they’ll even reverse the VAT rise? Well, we can dream.
I don’t want to overdo this argument – as I mentioned above, inflation in the economy eventually touches all things. But as another method of reducing the impact of price rises, it’s as well to be extra-vigilant.
Do you have any views on how to stop inflation destroying the value of your savings? Please share in the comments below!