Protect your portfolio against inflation erosion
The Bank of Canada raised its interest rate to 1.75% on Oct. 24. It said that CPI inflation dropped to 2.2% in September, but that its core measures remain around 2%. For many novice investors, this may sound like a foreign language. What do these various inflation measures mean? And in any case, 2% inflation seems really low, so do you really need to be concerned about it for your longer-term investment portfolio? The short answer is yes, you should take inflation into account, because it can seriously erode your purchasing power over the long term.
“Inflation” is broadly defined as the rate of increase in the price of goods and services over time. If the price of goods that you buy every day rises (and it always does) and your earnings or investment returns do not rise to keep pace, then your “purchasing power” has decreased. In other words, your dollar does not buy as much as it did a year ago.
In Canada, inflation is tracked monthly by Statistics Canada with the Consumer Price Index (CPI), which represents a typical basket of consumer goods. The Bank of Canada, which is responsible for monetary policy, also uses a number of more technical and statistically more accurate measures of inflation, which it calls “core” inflation measures, including CPI-trim, CPI-median, and CPI-common. Basically, these core measures strip out volatile or anomalous components of the broader monthly CPI to arrive at a more accurate metric. (The methodology is explained on the Bank of Canada’s website.)
The Bank attempts to keep the inflation rate somewhere about 2% annually, by adjusting monetary policy by raising or lowering its benchmark target overnight bank rate, buying and selling bonds, and issuing reams of reports and data on monetary and economic conditions. It even has an Investment Inflation Calculator that calculates the effect of inflation on investments over time. It’s an eye-opener.
For example, a $200,000 lump sum today will have purchasing power of only $134,594 in 20 years at the current annual 2.0% core rate of inflation. If we assume a conservative 5% annual investment rate of return on that $200,000, your investment plus return will grow to a nominal $530,659 in that 20-year period. But with the effects of inflation on both principal and interest, that total would actually have purchasing power of only $357,118. Add in taxes, and your “real” return will be even lower.
So you can see that when it comes to investments, it’s important to factor in inflation, especially if you’re an ultra-conservative investor seeking safety. In September, the broad Canadian CPI grew at an annual rate of 2.2%, while the Bank’s CPI-median core measure posted a 2.0% annual rate, right on the Bank’s target. As of Oct. 24, one-year Treasury bills were yielding 2.12%. After inflation and taxes, your real return on that supposedly “safe” T-bill after one year would actually be negative – you will have made no money, and you will also have lost purchasing power.
When preparing your financial plan and setting target returns, make sure you discuss the effects of inflation with your advisor. When you update your plan in the coming years, be sure to readjust the inflation rate you use to be consistent with the Bank of Canada’s target. And you should always target your desired investment return to be greater than the rate of inflation.
© 2018 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.