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The silent killer – the effects of inflation and purchasing power

If you held an investment for 15 years, would you prefer it to make nominal returns of 12.5% per annum, or 20.3% per annum? It may seem simple, but the choice is a lot more complex than most people realise. And the correct answer is: it all depends!

Most people think only about the nominal rate of return (ROR), without considering inflation. But during any given time period, you need to subtract this rate of inflation to understand your real return. For example, in the 15-year period between 1975 to 1990, the average ROR of the ASX200, including reinvestment of dividends, was 20.3% per annum. Inflation was running high at 9.8% per annum, so what we refer to as the ‘real ROR’ was actually 10.5% per annum.

In the time period between 1992 and 2006 the ASX200 returned 12.5% per annum and inflation averaged at 2.5%, so the real ROR was 10%. So these two rates of return end up being quite similar once we adjust it for inflation.

If the cost of goods and services is going up by 9.8% per annum and you make a 9.8% ROR on your investment, it may seem like a nice return, but you haven’t actually gained any additional purchasing power. On top of that you need to factor in tax. We say that high inflation is a silent killer; and tax is another. Your investment should be outgrowing the rising costs of goods and services, instead.

Another thing people don’t consider is the interest they receive on their everyday bank accounts. Bank interest rates are usually lower than inflation, which is another way you lose purchasing power.

Lately, inflation has run wild. We can either complain about it, or we can accept it and plan accordingly. But we’re all human, so chances are we will probably do both!

It doesn’t matter which time period you look at; over time, things will always get more expensive.

The RBA inflation target is 2.5% per annum. We call it the silent assassin that adds up over time and, because it’s hard to see, people don’t generally account for it. Let’s say you’re retired and need $100,000 to live on in 2024. 28 years later, you would need $200,000 to live the exact same lifestyle, given RBA’s target inflation. Even just four years later you would already need $110,000 for the same lifestyle. And if inflation happens to be 5%, then you would need double the extra amount.

When you retire, you need to match or, better yet, outpace inflation. Otherwise you’re moving backwards and losing purchasing power.