How you think about investment returns may need to change as inflation soars.
If you could choose between a 3% investment return or a 7% investment return, which would you pick? The answer seems obvious, so let’s add some context.
Which is better – a 3% investment return when inflation is 2% or a 7% investment return when inflation is 9%?
Once you allow for the impact of inflation, the 3% investment return is the more attractive as it outpaces inflation; the 7% return means lost
buying power over time.
The impact of inflation on investment returns has been a minor factor until recently. In the first 21 years of this century, inflation (on the
CPI measure) averaged 2.0% a year, exactly matching the Bank of England’s target. At that level, inflation still had an effect – prices rose
by a half over the period – but it has taken less than six months to become the rapid destroyer of wealth represented by current rates.
Today’s environment, with inflation forecast by the Bank of England to reach 10% later this year, is one that you and many other investors
may never have experienced during your adult life. Double digit inflation long predates the introduction of the CPI – it was last seen in
1990, when the official inflation yardstick was the now-discredited RPI (retail prices index – currently running at 11.1%).
In an inflationary environment you need to think of investment returns in ‘real’ terms, removing the eroding effect of inflation. So, in the example, the 3% return becomes a real return of 1% (3% – 2%) and the 7% return is actually –2% (7% – 9%).
Taking a ‘real’ view of investment returns means that short-term, deposit-based investments look much less attractive, despite
the recent interest rate increases. Beyond your necessary rainy-day reserve, you need a good reason to leave money on deposit, losing purchasing power.
Income and dividends
The past 13 years of near zero interest rates, combined with low inflation, have encouraged investors to focus on the capital growth element of investment returns. Until this year, young technology-related companies with no profits (and sometimes no revenue) flourished: investors could afford to wait for the promised bonanza, often years away. Inflation and rising interest rates have altered that perspective so that income, the other component of investment return, has become important.
However, inflation is not all bad news for investors. Many companies aim to keep their dividends growing at least in line with inflation over the longer term. While UK dividend payments fell in 2020 because of the pandemic, they recovered strongly in 2021 and are expected to continue growing in 2022. Link Group, a leading share registrar which monitors dividend payments, recently said that it expected regular dividend growth of over 15% this year.
If you want to protect your capital from the ravages of inflation, there are plenty of potential options, but none is without risk, so advice is important.
The value of your investment and any income from it can go down as well as up and you may not get back the full amount you invested.
Past performance is not a reliable indicator of future performance.
Investing in shares should be regarded as a long-term investment and should fit in with your overall attitude to risk and financial circumstances.