Investors often fear many things when making investment decisions. For some, market volatility and the potential for falling investment values top the list of concerns. However, inflation poses the biggest risk to investments and is one of the key metrics that deserves your full attention.

It is surprisingly easy to become accustomed to high inflation. While it is never comfortable, we tend to adapt, complaining about rising costs but ultimately getting by. Before the 2020 pandemic, the prime interest rate stood at 10.25% but dropped to 7% as the government sought ways to support the economy. Today, many of us long for those days when lower rates freed up cash, thanks to more manageable home, car, and credit repayments.

Now, we find ourselves facing a prime interest rate of 11.75% as the South African Reserve Bank battles to curb stubbornly high inflation. At 5.1% in June this year (down slightly from 5.2% in May), consumer price inflation (CPI) is not just squeezing your monthly budget – it is also eating away at your long-term investments.

Inflation destroys capital

Investment manager Dave Foord captured this point neatly in his book Time in the Markets, where he states that “the biggest destroyer of capital is inflation”.

What he means is that the real value of your wealth declines when inflation outpaces the returns on your investments. This erosion could mean falling short of your long-term financial goals, such as retirement savings.

If your investment income does not at least keep pace with inflation, maintaining your current lifestyle becomes increasingly difficult. For instance, if inflation is running at 5% per year, a basket of goods costing R1 000 today will cost R1 050 next year. While R50 might seem negligible, even modest inflation can significantly impact your future purchasing power over time.

The impact of inflation on investments

Let us explore how inflation can erode the purchasing power of a R1 million investment over a 10-year period, assuming the following conditions:

You are retired and invest R1 million in a fixed deposit that provides a 9.5% annual return.

You withdraw the entire return (R95 000 per year) as income without reinvesting any portion of it.

Assume a steady annual inflation rate of 5% over the 10 years.

When calculating the purchasing power of R95 000 over 10 years, adjusting for 5% annual inflation, the same R95 000 would only have the purchasing power of approximately R58 321 in today’s terms in 10 years’ time.

Over 10 years, while your nominal income remains R95 000 annually, the cumulative effect of inflation means that the real purchasing power of that income significantly diminishes. By the 10th year, the purchasing power of your annual withdrawal has fallen by about 38.6% compared to the first year.

The R1 million investment, while generating a consistent 9.5% annual return, does not grow in real terms since you withdraw the entire return each year. As a result, inflation steadily erodes the purchasing power of your income, leaving you with significantly less ability to buy goods and services over time. This illustrates the importance of considering inflation when planning retirement income, as maintaining the same withdrawal rate could lead to a noticeable decline in your standard of living over the years.

Four strategies to protect wealth from inflation

In short, inflation cannot be ignored. It has real consequences that impact your long-term investment returns. Here are four strategies that can help mitigate its effects:

  • Diversify your investments: Spreading risk across a mix of stocks, real estate, inflation-protected securities, and commodities can help balance your portfolio and reduce the impact of inflation.
  • Invest in inflation-resilient assets: Real estate with inflation-linked leases and companies with strong pricing power can help maintain your income and purchasing power.
  • Regularly review and adjust your portfolio: Stay ahead of inflation by monitoring your investments and making necessary adjustments. Consulting a financial advisor can be invaluable in this process.
  • Focus on growth investments: Stocks of companies with strong fundamentals and growth potential can provide returns that outpace inflation.

Personal inflation rate vs CPI

Let us make inflation more personal. Your actual cost of living could be significantly different from the metrics used to calculate CPI.

For instance, households across the country face steep annual increases in medical aid tariffs, electricity, property rates, and levies. This means your personal expenses might be rising faster than the official CPI figure.

It is crucial to factor this into your financial planning to ensure it delivers the long-term results you are aiming for. Ultimately, the best way to counteract inflation is to find investments that produce returns exceeding the inflation rate.

Your circumstances and goals are unique, so it is difficult to offer a one-size-fits-all solution. If you are concerned about the future value of your retirement savings, please reach out so we can explore the investment options that will help you achieve your financial goals.