How you think about investment returns may need to change as inflation soars.
If you could choose between a 3% investment return or a 7% investment return, which would you pick? The answer seems obvious, so let’s add some context.
Which is better – a 3% investment return when inflation is 2% or a 7% investment return when inflation is 9%? Once you allow for inflation, the 3% investment return is more attractive as it outpaces inflation; the 7% return means lost buying power over time.
Consider the real rate of return
In an inflationary environment you need to think of investment returns in ‘real’ terms, removing the eroding effect of inflation. So, in the example, the 3% return becomes a real return of 1% (3% – 2%) and the 7% return is actually –2% (7% – 9%). Taking this approach means short-term, deposit-based investments are much less attractive, despite interest rate increases.
The past 13 years of near zero interest rates, combined with low inflation, have encouraged investors to focus on the capital growth element of investment returns, favouring technology-related companies. Inflation and rising interest rates have reduced the appeal of distant profits and the other component of investment return, income, has now become important.
However, inflation is not all bad news for investors. Many companies aim to keep their dividends growing at least in line with inflation over the longer term. Link Group, a leading share registrar which monitors dividend payments, recently said that it expected regular dividend growth of over 15% this year.
If you want to protect your capital from the ravages of inflation, there are plenty of potential options, but none is without risk, so advice is important.
Investments do not offer the same level of capital security as deposit accounts.
The value of your investment and any income from it can go down as well as up and you may not get back the full amount you invested.
Past performance is not a reliable indicator of future performance.
Investing in shares should be regarded as a long-term investment and should fit in with your overall attitude to risk and financial circumstances.
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