The effect of inflation on your financial future

Inflation is a major factor in the realm of personal finance; it’s a risk that affects investment positively or negatively. In broad terms, inflation is the general increase in prices because of a change in the money supply or the availability of goods. It is not merely a macro-economic concept, since it is relevant to the finances of individuals in four primary ways:


· Determining the real return of an investment


· Evaluating the purchasing power risk


· Interest rates for savings


· Effect on financial instruments


The real return of an investment


This concept refers to the discounted nominal interest rate (rate after inflation is discounted). In the realm of investment, this effect is referred to as inflation risk. Although this risk has a significant effect on investors, the combined risks of taxation and inflation are far more serious than inflation risk on its own. A good example is the treatment of deferred annuities, where tax is paid on annualized payments and the payments are typically fixed. Even after discounting for inflation, tax must be levied against the accumulated nominal returns (and not the discounted one – unfortunately). The real return is further eroded by the effect of inflation on the payments received.


Purchasing power risk


Inflation is also influential in this aspect of investment risk. The loss of purchasing power on investment returns is tied to the reduced purchasing power per dollar. Purchasing power risk affects the capital invested significantly. With low-yield investment instruments, the purchasing power of the principal declines rapidly.


Interest rates

In macro-economics, there is a link between inflation and interest rates; a link that filters down to the individual. One of the methods of controlling inflation is to increase prime lending rates in an attempt to discourage borrowing. High interest rates also make investing more attractive than consumption, which reduces aggregate demand in the economy.


Financial instruments


Interestingly, inflation is not always a bad thing. Certain financial instruments benefit from high inflation. Usually these are the types of investments that have intrinsic value, because such assets remain in high demand regardless of the level of inflation. Examples of such assets include art, real estate, gold and other commodities. High inflation increases the absolute returns on such investments. Notice that the opposite happens with regard to cash/income instruments like savings accounts and money market funds. When inflation is low, it is less risky to invest in cash and income options.


While many persons who are risk averse are afraid to “lose,” inflation causes real loss for the ultra-conservative investor. Portfolio diversification is not only important in managing market risk, but can also mitigate inflation risk. While limiting investment in growth options reduces market risk, increasing investment in them reduces inflation risk. It is a trade-off that emphasizes the delicate balance of diversification. Such information can only redound to the benefit of a prudent investor.