In a world where financial stability is crucial, knowing the real worth of our money is essential.
According to the latest data from the Bureau of Statistics consumer price index, today’s prices stand at 1.06 times the average prices since 2022. This means that our wallets are feeling the pinch as each dollar in our hands only stretches to buy 94.088% of what it could just a few years ago.
In this article, we’ll explain inflation, how it affects buying power, tackle common investment strategies for inflation, and why investing early may help safeguard your hard-earned money from losing value.
Understanding Inflation and Its Impact on Purchasing Power
Inflation occurs when prices for goods and services rise over time, causing your money to purchase less. When inflation rises, each dollar you have buys fewer goods, lowering the value of your income and savings.
Various factors contribute to an inflationary environment, including production costs, demand dynamics, and government policies.
Cost-push inflation occurs when businesses pass on increased expenses to consumers through higher commodity prices while demand-pull inflation occurs when consumer demand outstrips available supply, leading to price hikes to balance the market.
Government policies such as taxation and spending, can impact aggregate demand and supply, influencing price levels. Monetary policy set by central banks, such as adjusting interest rates or managing money supply, can also impact borrowing costs, investment decisions, and overall economic activity, all of which have implications for inflation.
In Australia, the annual consumer price index reached 7.3% in September 2022, causing a significant increase in the cost of living, particularly for essentials like food and non-alcoholic beverages, which saw a 9.0% inflation rate.
Consider a typical Australian family whose monthly grocery bill is $500 before the inflation surge. With the consumer price index rising by 7.3% and food prices specifically increasing by 9.0%, their grocery expenses would escalate to $546.50 post-inflation.
The $46.50 difference in monthly expenses can strain a family’s budget, prompting adjustments or seeking cheaper alternatives, highlighting the impact of inflation on everyday life and reducing the quality of living in Australia.
Investing as a Hedge Against Inflation
Investing can offer you opportunities for growth that exceed the inflation rate, safeguarding the value of your wealth and ensuring its purchasing power remains intact in the face of rising prices.
By allocating your funds to various investment vehicles, you may potentially outpace inflation and preserve the purchasing power of your wealth over time.
Although past performance is not indicative of future performance, historically, all asset classes as a group generated significantly higher returns with low and stable inflation, but significantly lower returns with rising inflation.
Importance of Investing Early
Investing early is crucial for you to leverage the power of compounding interest for wealth growth putting you in a better position to overcome inflationary environments.
Compound interest is an investment strategy where an asset’s earnings, either from capital gains or interest paid, are reinvested to generate additional earnings over time. It facilitates the growth of the initial investment and generates further returns on that investment.
For example, if you invest $10,000 and earn 5%, you’ll make $500 the first year. You start the second year with $10,500, earning $525 from 5% returns. If you continually reinvest returns, you’ll have a total savings of $12,763 in 5 years.
Now imagine, if you started with $1,000 and regularly deposited $1,000 every year for 20 years while also reinvesting earnings from 5% returns. This calculator shows you will have a total savings of $35,719.
Strategies for Early Investing
Initiating investments as soon as possible allows compounding to work its magic, leading to substantial returns over time. Here are key investment strategies to get you started:
1. Define Financial Goals: Before investing, establish clear financial objectives such as retirement savings, buying a house, or generating cash flows. This helps tailor your investment approach to meet specific needs.
2. Create a Long-Term Investment Plan: Developing a long-term investment strategy is crucial for sustained growth. Consider options like managed funds, index funds, ETFs, or value investing based on your risk tolerance and goals.
3. Consistency in Contributions: Regularly contributing to your investments, regardless of the amount, is key. Even small contributions may potentially accumulate significantly over time due to compounding interest.
4. Understand Investment Choices: Educate yourself on different investment vehicles like shares, bonds, and managed funds to build a diversified portfolio aligned with your goals and risk tolerance.
Diversification and Risk Management
Diversification is a fundamental investment risk management strategy that hedges against inflation and various risks. It involves distributing funds across different asset classes, industries, and geographical locations, such as buying shares in Australian and overseas companies or investing in property and gold.
A diversified portfolio helps minimise the exposure to specific risks associated with individual assets, industries, or sectors while maximising returns.
You may also manage risk and possible returns by altering the proportion of each item in your investment portfolio. For example, you may invest more in assets, such as property or gold, that perform well during inflation.
Note that diversification may limit short-term gains, but it plays a vital role in protecting capital and enhancing long-term investment stability.
Investment Vehicles to Combat Inflation
Mitigating inflation is crucial for maintaining economic stability and prosperity. One effective way to combat inflation is through investing in assets that may outpace or mitigate the effects of rising inflation. Here are some investment vehicles commonly used to combat inflationary environments.
Shares
Investing in shares of companies listed on the stock exchange may provide a hedge against inflation. Historically, equities have shown the potential to outperform inflation over long periods. (Remember: past performance is not indicative of future performance!) To maximise the benefits of investing in shares, consider utilising dollar-cost averaging.
Dollar-cost averaging is a systematic investment strategy where investors invest a fixed amount at regular intervals, reducing market volatility and average cost per share. It helps mitigate market timing risks and allows investors to focus on long-term goals.
Property
Real estate may potentially outstrip inflation, and generate rental income and capital appreciation, but it’s not immune to market volatility and maintenance expenses.
Additionally, Australian-listed commercial property trusts (also known as real estate investment trusts – REITs) and housing have shown reasonable returns over time. REITs are traded on the Australian Securities Exchange (ASX), enabling investors to invest in large commercial assets like shopping centres, office buildings, and industrial properties, which they may not access independently.
Inflation-Protected Securities
In Australia, Inflation-Protected Securities (IPS) are primarily Treasury Indexed Bonds (TIBs) and their exchange-traded indexed bonds (eTIBs) equivalents, issued by the Australian Government as a unique way to combat inflation.
Treasury Indexed Bonds (TIBs) and their exchange-traded indexed bonds (eTIBs) are designed to adjust the capital value of the investment based on movements in the Consumer Price Index (CPI). This adjustment ensures that investors are shielded from the erosive effects of inflation, as both coupon payments and the face value of the bond increase in line with changes in the CPI.
Precious Metals
Assets like gold, platinum, and silver are often considered hedges against inflation. However, their real returns have been relatively low on average over the years.
Superannuation Funds
Australian superannuation funds play a significant role in wealth management and retirement planning. These funds use various investment strategies, including derivatives and cash holdings, to manage risks and maintain liquidity during market fluctuations.
Balancing Short-Term and Long-Term Financial Needs
Balancing short-term financial objectives with long-term wealth creation requires careful financial planning, investment diversification, and consistent monitoring of investments.
Things to Consider
Your finances: The first step is to thoroughly grasp your financial condition. Determine your investment capacity by assessing your assets (e.g., house, savings, investments, debts, liabilities).
Your Financial Goals: Identify and categorise your financial objectives as short-term (0-2 years), medium-term (3-5 years), and long-term (5+ years). This framework will guide your investing decisions.
Your Risk Tolerance: Investments with larger potential profits are frequently associated with more risk. Identifying your risk tolerance helps guide your investing decisions.
Strategies to Create a Diversified Portfolio
Research Investment Options: When deciding on investments, consider aspects such as projected returns, time period, risk, liquidity, cost, and tax consequences. Make decisions that match your objectives and tolerance for risk.
Build Your Portfolio: Your portfolio should represent your investing objectives, time, and risk tolerance. Lower-risk investments are appropriate for short-term goals, whilst riskier assets may be explored for long-term goals. Diversification across asset types is crucial for minimising risk.
Monitor Investments: Review your portfolio regularly to ensure it aligns with your financial objectives. Adjust as needed if your circumstances or goals change.
The Importance of Regular Review and Adjustment
Investing necessitates ongoing monitoring and adjustments depending on changes in economic conditions and your circumstances.
Marriage, having children, changing careers, or retiring may all have a significant impact on your financial circumstances, necessitating a reconsideration of your investment plan.
Regular evaluations are particularly necessary during periods of economic volatility or inflation. This enables you to fine-tune your approach based on how asset prices perform under certain situations.
During high inflation, tangible assets like real estate or commodities do well, but investments with fixed interest rates like bonds may underperform due to the loss of real value in interest payments.
Rebalancing, or altering the proportions of your asset classes to retain your initial allocation, is another important component of reviews. It entails buying and selling assets regularly in order to preserve the original asset allocation.
Assume you started with an asset allocation of 60% shares and 40% bonds. Say share prices rise because of their outstanding performance this year, thus your shares might have grown to account for 70% of your portfolio. To return to your previous 60/40 allocation, you would need to sell some equities and buy more bonds.
Wrapping Up
Inflation is a common economic phenomenon that reduces the buying power of your money over time. Understanding its influence is critical for making sound financial choices. A well-planned investment strategy implemented early on may protect your money from inflation and ensure your long-term purchasing power.
Investment alternatives vary in risk and possible returns, so it’s important to choose assets that align with your financial goals and risk tolerance.
You may safeguard your money against inflation by investing early, taking advantage of compound interest, diversifying your portfolio, and constantly assessing your assets. It is never too early or too late to begin investing and take control of your financial destiny.
Ready to Build an Investment Portfolio?
While investing may seem complicated and time-consuming, it doesn’t have to be that way with knowledge and expert guidance. Whether you’re young or old, it’s never too late to start investing, so you may achieve your goals.
Need investment advice? Coastal Advice Group can work with you to tailor your investment plan and build your portfolio. Our financial advice team can help you establish direction for your investments to achieve your financial and lifestyle goals.
Call us or book online to secure your consultation today!
References:
https://www.firstlinks.com.au/inflation-impacts-different-types-investments
https://www.aofm.gov.au/securities/treasury-indexed-bonds
https://www.australiangovernmentbonds.gov.au/bond-types/exchange-traded-treasury-indexed-bonds
https://moneysmart.gov.au/investments-paying-interest/bonds
https://www.in2013dollars.com/australia/inflation/2022?amount=1000#buying-power
https://www.rba.gov.au/education/resources/explainers/australias-inflation-target.html
https://www.firstlinks.com.au/inflation-impacts-different-types-investments
https://www.rba.gov.au/publications/confs/2023/pdf/rba-conference-2023-wood-chan-coates.pdf
https://www.aofm.gov.au/securities/treasury-indexed-bonds
https://www.australiangovernmentbonds.gov.au/bond-types/exchange-traded-treasury-indexed-bonds
https://moneysmart.gov.au/investments-paying-interest/bonds
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