Tuesday, January 20, 2015

Inflation and the Investor: Keep a Close Eye on Your Real Returns.

Inflation, or the increase in general price levels over time, slowly erodes the purchasing power of investors. Inflation is not always a constant, as there have been periods of deflation, or a general decrease in the price level, but periods of deflation are fewer and farther between. In Canadian history, the harshest and most prolonged period of deflation was during the Great Depression, when general price levels declined by more than 20 percent over a four year period. Inflation, on the other hand, is a regular and much more pervasive problem for the investor. In the early 1980’s, the Canadian rate of inflation was over 12 percent, but it has since fallen to a level within the Bank of Canada’s prescribed rate of 2 percent per annum. For the investor, this means that any asset you own must appreciate in value, or return to you in dividends or interest, a minimum of 2 percent per year. However, should inflation increase, which it will at some point, you must be careful to increase your minimum required rate of return.

In simple terms, investors or owners of wealth face the danger that their money will purchase less and less goods and services over time, while borrowers of money actually benefit from being able to pay back their loans with money that is actually worth less and less over time. Should inflation be higher than expected, the loaners of wealth suffer, and the borrowers of wealth benefit. Typically, the average investor loans money by investing in fixed income securities, such as Canada Savings Bonds, Corporate Bonds, GIC’s, etc. And in return, the borrowers promise to pay back the loans with interest. Determining what the interest rate should be can be very complex, but to start with, we will discuss why inflation is such an important component of this decision.

Fixed income (investments that promise to return a fixed amount) investors must be particularly attuned to the ever present threat posed by inflation because it will have a major impact on their overall returns. Since most conventional fixed income securities return your principal (the amount you invested) at a future date, you want to make sure that your principal still has a certain measure of value once you can re-invest or spend it at maturity (the date when you are scheduled to receive your principal). For instance, should you purchase a 10 year, $5,000 bond, when you go to redeem your bond in 10 years, if inflation has ran at 3% per year, it has eaten away almost $1700, or 35 percent of your purchasing power. Now, if your bond had been paying you 3% per year to own it ($1500 in total), you have limited the danger that inflation has on your portfolio by achieving a real return (or return after deducting for inflation) of about 0%, assuming that you re-invested any interest payments. If you spent the interest money, you would have actually lost $200 in real terms.

Note the uncertainly present in the above discussion of owning the 10 year bond. What if inflation is more than you expect? What if you purchase the 10 year 3% bond and inflation over the 10 years is an average of 5%? You essentially have a fixed income investment losing you 2% per year in real terms. To help mitigate the risk of higher than expected inflation, investors can do a few things: 1) you can buy bonds that mature (pay back your principal) sooner rather than later, 2) you can stagger when your bonds mature so that you can re-invest your principal at different times, 3) you can purchase a fixed income security called a real-return bond, which adjusts its return based on the inflation rate. Of course, the reverse of higher than expected inflation could occur, and you could experience a period of lower than expected inflation. In this scenario, your bond investments would result in a higher than expected real rate of return, and in some cases, you could even sell your bonds for a capital gain before they mature.

          In contrast to bonds, equities (partial ownership in a business, or most commonly called stocks) provide the investor with a more natural way to protect themselves from inflation. There are a number of reasons for this. To begin with, equities (excluding preferred shares), do not provide the investor with a fixed rate of return. Should the business increase its profits over time, shareholders should experience an increase in the price of their shares, their dividend payments, or both. An effective and well-run business in the right industry will also be able to increase its prices and pass the costs of inflation on to the consumer rather than its investors. This should result in higher revenues to help compensate for any increased costs that the business might face. This is common for many businesses in food retail and processing, such as Loblaw (TSE: L), Metro (TSE: MRU), and Hershey (NYSE: HSY). Should their cost of inputs rise by 4%, they often pass those costs on to the consumer through higher prices over time.

          Additionally, an investment in a business with tangible assets, such as land and buildings, gives you ownership in things that increase in value over time as inflation eats away at the value of everyone’s money. For instance, a corporation such as CN Railway (TSE: CNR) owns large tracts of land, another such as RioCan Real Estate (TSE: REI.UN) owns an array of retail properties. Both investments hold assets that generally increase in value during periods of inflation. As the value of a company’s assets increase over time, share prices should follow, which helps provide the investor with the capital appreciation that they need to keep ahead of inflation.


          Other popular investments available to help protect the investor during periods of high inflation might also include gold, silver, and other minerals, or even commodities like oil and natural gas. Typically, when investors fear that the value of money is going to decline, gold acts as a “safe-haven,” or place where people store the value of their money for a certain period of time. Investors can purchase physical gold bullion, or they can buy shares in gold producers, such as Goldcorp (TSE: G); in both cases, returns often vary wildly, and they can be very hard to predict. There are many supply and demand factors and other risks to consider when investing in metals and mining, or oil and gas. However, there is room within a well-diversified portfolio for many of the above mentioned ideas. These include fixed income, equities, metals, and commodities. As mentioned in the last article concerning Investment versus Speculation, be careful to always do your research on any and all investments, develop a well coordinated plan for buying and selling, and stick to your plan. 

Happy Investing! 

Matthew. 

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