When it comes to your finances, inflation can be a silent wealth killer.
Investors often underestimate the damaging effect inflation can have on their wealth. Increase in the cost of living can reduce the spending power of your money. Over decades, the effect can be dramatic.
The graph below illustrates how the value of £100 in your pocket could have been eroded by the effects of 1%, 2% and 5% inflation over the last 10 years.
In the worst case scenario below, if inflation were to average 5% a year over a 10-year period, your £100 would be worth just £55.
How the value of £100 in your pocket can be eaten away by inflation
Inflation can be good for holders of assets, if their values rise faster than the general level of inflation. This could include houses, commodities such as gold and some shares.
However, it can be bad for anyone with a fixed income: pensioners and for workers with weak wage bargaining power. Inflation is most tangible with everyday goods. It can explain why a Mars bar that cost 26p in 1990 costs 60p today.
Global inflation has been low in recent years compared to historic norms. In the 1980s it was as high as 14%, and peaked at a little over 10% in the 1990s, according to data from the World Bank. For the last two decades, the norm has been around 4%, apart from a brief period before the global financial crisis. With the global economy still not back to full health, pressure on prices has been weak and inflation fell to as low as 1.5% in 2015.
Very low or very high inflation is damaging to the economy. Central banks are usually tasked with keeping inflation at 2% in order to maintain a stable and healthy economy, or a “Goldilocks Economy” – not too hot, not too cold. They mostly use interest rates to do this, although in the post-financial crisis era they have also deployed more unusual policies, such as programmes of quantitative easing.
Of course, this damage to your wealth can be mitigated. Putting the money into a savings account will earn interest. Investing it has the potential to offer better returns, although your capital is at risk.
The challenge, therefore, is to achieve investment returns that keep ahead of inflation. As the billionaire investor Warren Buffett put it, “Arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislature. The inflation tax has a fantastic ability to simply consume capital.”
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