Inflation and Investment

Whichever way you measure it - RPI or CPI - inflation is up again. This is not a major surprise and I would be quite happy if it peaks at its current level and starts subsiding again, which is what the government and the Bank of England are saying - but I'm not holding my breath! Usually when governments print money, even if they re-label it quantitative easing, inflation generally rises at some stage. Those of us who are old enough will remember the 20% plus inflation rates of the mid-70s!

Paradoxically, it would appear that inflation is good news for those who have borrowed money.Interest rates will usually go up in an inflationary environment so it probably doesn't feel that good initially. But if the interest rate charged is less than the inflation rate and the capital value of the loan is obviously losing value over time, then those who come out of inflationary periods best are often those who have borrowed a lot of money. If you have an inflation rate of even 10 % and are paying 20% on your credit card, then it doesn't work. But if you have fixed rate mortgage of, say, 3.5% and inflation is 10%, then you're doing quite well.

Call me cynical but who is biggest borrower? It's the government! It would be a very pleasant silver lining for government debt if there was a period of inflation - I wouldn't suggest for one minute they were deliberately stoking up but it would benefit them. There is no doubt, however, that investment is a big worry during a period of inflation. Cash in the bank will almost certainly lose money. If you have money in a normal taxed account, most of time it will be losing value to inflation. If your money is earning 3.5%, by the time you knock off 20% tax, the rate will be less than inflation. Money rarely even maintains value when sitting in the bank so this should be only short term to cover what you will be paying out in next 12 months or what you might need for emergency. Everything else ought to be invested to at least maintain its buying power or ideally increase it - one definition of investment is deferred consumption. Unfortunately the main assets that achieve this are volatile, such as shares and commercial property. Admittedly if you put some of your money into each, because they are volatile but tend to be out of step with each other you do get an average of returns that takes a bit of the volatility out of fluctuations in value. However, this still would only suit the adventurous investor who is comfortable with the value of their money on paper dropping.

In the normal way, adding some "stodgy stuff" like government stock or corporate bonds can tone down the risk in an investment portfolio - but again unfortunately in inflationary times, if you own these you are the lender not the borrower so if the economic climate is favouring the borrower it won't help you, the lender. Yes, you will get some benefits from the diversification, but fixed interest investments tend to do worse in inflationary times. Of course there are inflation linked government bonds where both the capital redemption value and the income payments go up by the same as the RPI, which is useful at present as this is higher than CPI.But if you bought now, between the purchase and whenever the fixed date redemption falls, it would not be a smooth track. Supply and demand will move the price up and down until the final redemption date which is the only date when you know for certain what you will get. If you want to sell before then you will have to take whatever the market is willing to pay.

A combination of shares, commercial property and index linked gilts is quite a useful cake mix for inflationary times - how much of each individual ingredient you buy would depend on the amount of investment risk you are comfortable with. If you are risk averse, you will have less of the high volatility elements and more of the low volatility but again, over time, the lower the risk of the portfolio the lower the returns. Diversification is the nearest thing to a free lunch but in the broader picture, if you've got a relatively low volatility portfolio it will make a relatively low return.

Other things bandied around as good in inflationary times are commodities, though I'm personally not a big fan. The argument goes that if the value of money declines and there is only fixed amount of commodity in the world the price will go up. That is the theory but there have been long periods when commodities have been volatile but getting low returns. The other downside is that commodities don't generate any income. Fixed Income investments generate interest, shares generate dividends, commercial property generates rents and so on but as a major investment component I'm not convinced about commodities as a large part of a portfolio.

So most people have to go back to "the big three" questions - what are you looking for money to do, how long have you got for it to do it and how much risk are you comfortable with and are prepared to take? Then you work back from there.


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Paul Duckworth is a Chartered Financial Planner and Fellow of the Personal Finance Society, licenced to advise UK residents. He specialises in Retirement Planning, Investment, Tax Planning and advising business owners.Want to know more? Click on the link! => http://www.paul-duckworth.co.uk