For the layman, inflation basically means that the prices of goods and services keep going up (without the same increase in your income). According to the official statistics, our CPI is around 2-3%%. However, most of us actually experience a higher inflation rate than that because we consume a lot of items which are not counted in the CPI. I estimate the inflation rate to be at least 4% to 6%, depending on the items you actually purchase.<\/p>\n
Here\u2019s a very simple example to illustrate the impact of inflation on your money using a 6% average inflation rate as well as its impact when you\u2019re looking at a 4% annual investment return.<\/p>\n\n
| Now<\/td> | 12 years later<\/td> | 24 years later<\/td> | 36 years later<\/td> | With the starting capital of RM3 million in capital and an inflation average at 6% annually, it takes only about 12 years for the value of the wealth, in today\u2019s Ringgit, to decline by 50%.<\/p>\n In other words, if you took RM3 million and buried it in your garden, then dug it up 12 years later, your money would be worth only half as much as it is in current Ringgit terms as when you buried it.<\/p>\n And every 12 years thereafter, its value would likewise be reduced in half. So, this is the first negative impact of inflation \u2013 it destroys capital<\/strong>.<\/p>\n Inflation of 6% equally has a negative impact on our income over time. A 4% return on RM3 million invested would yield RM120,000 annually. But at the same 6% inflation rate, the purchasing power of that income in 12 years would only be half as much as it is today. So effectively, the returns on your investment would reduce by 50% every 12 years.<\/p>\n Of course, the returns won\u2019t actually reduce but what you can get for it will.<\/p>\n For example, if you bought a cup of coffee for RM2.20 today, it would double in cost (RM4.40) in just 12 years from now. Which means that\u00a0 effectively your RM120,000 income can only give you half of the current purchasing power 12 years later. Another 12 years, the purchasing power would have reduced by another half. After 36 years, the investor would need to get by on one-eighth of the purchasing power with which he had started.<\/p>\n As this example shows, inflation is a very serious problem.<\/p>\n Psychological studies show that we feel the pain of a dollar lost twice as much as a dollar won. Obviously, none of us enjoy losing our investment capital.<\/p>\n Let\u2019s assume our target is to achieve a 10% annual gain compounded for the next 5 years which is roughly a 61% gain on our initial capital (ah the magic of compounded interest J). \u00a0Now, to demonstrate how much it\u2019ll hurt for us to recover from a loss on capital value in JUST the first year, here\u2019s a table on the appreciation we\u2019d need to achieve in the following 4 years to ensure we achieve the original target returns.<\/p>\n As you can see, in this example of inflation with just a loss of value equivalent to 6% in the first year the impact on our following years is extremely harsh. Requiring us to increase our yearly yields by almost 50% to compensate (From 10% to 14%).<\/p>\n As the example above illustrates, the bigger the loss on our principal capital, the higher the return on investment (ROI) we will need to generate in order to achieve our original investment target. To achieve a higher return on investment, we would need to take more risks. In short, the careless loss of current created wealth would definitely make our investment job tougher. Now we can understand better why Warren Buffett\u2019s first rule in investing is \u201cNever lose your money.\u201d<\/p>\n As you can see, inflation plays an important role in our investing. And if it erodes your investment returns this much, just image where you would be if you had no investments in place at all? This is exactly why it\u2019s key for us to ensure we have investments in these trying times. You may not see the gains you\u2019d like but you would be able to at least maintain your capital value which is key \u2013 it\u2019ll allow you to come out much stronger once the good times roll around!<\/p>\n Like any investment, during this period it\u2019s essential that we be extra vigilant in our asset allocations in order to ensure our money is safe.<\/p>\n So, what are you waiting for? Start weighing your options cautiously and optimise your money now. |
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Yap Ming Hui (yapmh@whitman.com.my) is a bestselling author, TV personality, columnist and coach on money optimisation. He heads Whitman Independent Advisors, a licensed independent financial advisory firm which has helped people to optimise their wealth and achieve financial freedom since 2000.<\/div><\/div><\/p>\n