As investors, you need to understand the effects of inflation on your investment portfolio. Here’s an introduction to the world of nominal and real investment rates.
By Mike Jaczko, BSc. Phm, RPh, CIM®
Inflation is the rate at which the general level of prices for goods and services in an economy is rising. As a result of inflation, the purchasing power of a unit of currency like the loonie falls. For example, if the inflation rate is 2%, then an item that costs $1 in a given year will cost $1.02 the next year. As goods and services require more money to purchase, the implicit value of that money falls. The primary purpose of central banks in an economy is to generally limit inflation and avoid deflation.
The money supply
Monetary theory believes that inflation is related to the money supply of an economy. Over the past several years, many investors have been worrying about the inflationary effects of all the money that central banks around the world have “printed”. Specifically, there is a concern that the rapid increase in money supply could potentially cause prices in the general economy to rise. If this happened, the value of money would fall, contributing to further economic problems and hardships.
How inflation affects your investments
The impact of inflation on your portfolio depends on the type of securities you hold and the length of time for which you hold them. If you invest only in equities (stocks), worrying about inflation shouldn’t keep you awake at night: over the long term, a company’s revenue and earnings should increase at the same pace as inflation. However, in the shorter term, the combination of a lousy economy and a precipitous increase in costs is generally not a good omen for equities.
The main problem with stocks and inflation is that a company’s returns often are overstated. In times of high inflation, a company may look like it’s prospering, when inflation is the real reason behind the growth. When analyzing financial statements, it’s also important to remember that inflation can wreak havoc on earnings depending on what technique the company is using to value inventory. Veteran pharmacy operators are sure to remember (not fondly) the high inflation economy of the ‘70s and ‘80s.
Fixed-income (bond) investors are the hardest hit by inflation. Back to our previously learned lesson about the time value of money: suppose that a year ago you invested $1,000 in a government issued treasury bill with a 9% yield (we can only wish). At the point when you are about to collect the $1,090 owed to you, is your $90 (9%) return real? Assuming inflation was positive for the year, your purchasing power has fallen and, therefore, so has your real return. We have to take into account the chunk inflation has taken out of your return. If inflation was 4%, then your return is really only 5%.
Nominal rates versus real rates
This example highlights the difference between nominal interest rates and real interest rates. The nominal interest rate is the growth rate of your money, while the real interest rate is the growth of your purchasing power. In other words, the real rate of interest is the nominal rate reduced by the rate of inflation. In our example, the nominal rate is 9% and the real rate is 5% (9% – 4% = 5%).
Savvy investors must always consider what the real rate of return on an investment is. Unfortunately, investors often look only at the nominal return and fail to consider their purchasing power altogether. In a future article, we will elaborate on how inflation and a rising interest rate environment adversely affect the value of a bond portfolio.
Mike Jaczko, a pharmacist by background, is a portfolio manager, partner and member of KJ Harrison, a Toronto-based private investment management firm servicing individuals and families across Canada. For more information on this topic, email firstname.lastname@example.org.