With inflation rising, should you rethink investment returns?

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From January 2000 to the start of 2022, inflation, as measured by the Consumer Price Index (CPI), averaged 2.3%. It has now (November 2022) jumped to 11.1% in the 12 months to October, the highest for 40 years. That means that if you were born after the early 1980’s, you have not experienced the sort of economic environment we are now experiencing.

What is the ‘ideal’ level of inflation?

When inflation is around 2% – the Bank of England’s government-given target – it goes virtually unnoticed. Economists reckon some inflation is necessary to keep the wheels of the economy moving and that 2% is about the right level. Prices still increase, but they do so slowly and are balanced to a degree by other prices falling. At 2%, the phrase ‘cost of living’ is not automatically followed by the word ‘crisis’.

With inflation at today’s high rate, the picture is radically different. Inflation is suddenly no longer something running under the surface.

How does inflation impact investment?

When it comes to investment, financial advisers have always taken inflation into account by considering ‘real’ returns, in addition to your objectives and risk capacity. These are calculated by deducting the inflation rate from the investment rate of return (the nominal return). For example, if an investment return is 8% and inflation is 6%, the real return is +2% (8% – 6%), but when inflation is 2%, the real rate of return is 6% – three times as much. Real returns, like their nominal counterparts, can also be negative.

‘Real’ rates of return

A negative real rate of return means that your investment’s buying power is shrinking. The higher inflation, the more important it is to think in terms of ‘real’ rather than nominal rates. A good current example is the savings market, where the top rates have risen in response to the Bank of England’s base rate increases. You can now earn over 4.36% on a 1 Year Fixed Term Deposit, the best nominal rate for several years, but still the worst real rate for many years because of inflation.

Rising inflation continues to represent a challenge to savers, who must at the very least aim to beat it to prevent their money from losing value in real terms. The current challenge is made even trickier by the fact that current savings rates are  still much lower than  inflation at its current levels, it is presently impossible to find a deposit-based account that can beat inflation.

So how can cash savers hope to bridge the gap?

The answer may be to invest in 'real assets' such as shares, fixed interest, and property.

But is this a good time to invest? It`s all too easy to get caught up with some of the news we regularly hear about financial markets. The key factor, however, is not about when to invest but rather the amount of time you invest for.

When should I invest?

Many people believe that knowing when to buy and when to sell is the secret of successful investing. The truth is that no one knows with certainty when investment markets will rise or fall. Trying to time the investment markets is not only stressful, but also very seldom successful. Leaving funds invested for the medium to long term, for those who can afford to do so, usually produces the best returns.

Our philosophy is that no one can predict the peaks and troughs of financial markets with any accuracy, and it has always been extraordinarily difficult to time when the best (peaks) and worst (troughs) are. Timing the stock market is extremely difficult, so we believe it is best avoided.

Volatility is a part of investing, which is why we always take time to understand how much risk any client is prepared to take before investing. We also generally believe in the benefit of diversification of assets to help manage some of the extremes of the markets. Taking a diversified multi-asset approach means that some assets can fair better in different market conditions as they are more defensive assets, such as bonds, whereas during periods of growth equities tend to fair better.

We have produced “Our Guide to Investing” to help you understand, whatever your knowledge and experience, the principles of investing to allow you to make informed decisions. You can download the guide here.

At Armstrong Watson, our quest is to help our clients achieve prosperity, a secure future and peace of mind. We believe that for those people who are considering taking financial advice in relation to their savings and investments it may be a good time to do so to utilise existing allowances and tax reliefs.

Past performance is no guarantee of future performance. The value of investments can fall as well as rise and investors may not get back their original investment.