"Inflation has turned £100 into less than £20"
One stockbroker explains the corrosive effect of inflation.
One stockbroker explains the corrosive effect of inflation.
6:00AM GMT 19 Nov 2011
How would you feel if you bought a security for £100 back in 1971, and it was worth less than £20 today? Unfortunately, if you are over 60 years old, as I am, you will probably have done exactly this, as this is how much the purchasing power of sterling has fallen over this period.
To put it the other way around, had I gone into a supermarket 40 years ago and bought a trolley of goods for £20 and then returned to the supermarket today to buy the same trolley of goods, it would cost me £240.
Inflation is the most insidious investment risk, but its destructive power is frequently ignored by investors and financial regulators alike. There is a tendency to believe that if you save a pound, then, providing you get your pound back, plus a return while you were not using the money, all is well.
Wrong! Money is simply a form of exchange and its true value is determined by what it can purchase, not by its face value.
For the value of your money on deposit to hold its purchasing power, you would have to generate an interest income, after tax, equal to the rate of inflation. Even to a standard-rate taxpayer, that demands a return of 6.25pc with inflation at 5pc. What is more, you can't spend it – you have to save it.
Even over the past five years, from October 2006, the purchasing power of £1 has fallen to 84p.
Where is inflation going from here? The truth is that while short-term inflation can be predicted with some accuracy, and in the short term it is likely to decline as certain known increases of a year ago fall out, no one knows where it is going in the longer term.
There hangs the rub. Many commentators, and I would count myself among them, believe that the level of quantitative easing being undertaken by the Bank of England will result, in the longer term, in further serious – if not hyper – inflation.
In such an environment, monetary assets will decline in purchasing power, while, on the basis of historical precedent, physical assets such as property and shares will maintain their value in real terms.
The conventional wisdom, as one gets older, is to reduce exposure to equities and increase the money on deposit or in fixed income. The risk in this is that we have no idea how long we will live for, but with increasing life expectancy one is potentially exposing oneself to inflation risk for an indeterminate period of time.
Historically, this made sense – as shares generated less than fixed-income securities, so it was logical to go for the higher income and greater certainty. However, today, with the London equity market yielding 4pc after tax, equivalent to 5pc before tax, it is difficult to get an improvement from long-dated fixed-income securities and impossible from gilts or money on deposit.
I would therefore advise a higher equity content for portfolios today and, while I recognise that it is difficult to do so, I would also urge an investor to try to ignore the volatility in capital values, both good and bad, and focus on the dividends.
History tells us that over the years dividends have more or less maintained their purchasing power relative to inflation throughout most of the chaos that the world has thrown at us, and they have done so by steady growth and none of the volatility shown by the equity capital values.