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Recovering the angels’ share

by | Apr 16, 2014 | SELF-PUBLISHED

How to prevent inflation evaporation in your portfolio

Scottish distillers call the routine evaporation of a small amount of whisky during the distilling process “the angels’ share.” Likewise, inflation is quietly evaporating your retirement nest egg, your investment portfolio, and your purchasing power. Except it gets bigger every year. And there’s nothing angelic about it. It can seriously damage your financial health over the longer term. Here’s why, and what you can do about it.

Inflation refers to the increase of prices over time as measured by the consumer price index (CPI). If the prices of items that you purchase every day, like milk, eggs, and bread, increases over time and the amount of money you make or the return on your portfolio does not exceed the increase, then your purchasing power has decreased. Inflation is one of the main reasons why investors often look for more aggressive investments than, say, a plain vanilla guaranteed investment certificate (GIC). Your investment return will need to pay for the increased cost of goods in the future after inflation and taxes, and the current return on GICs after taxes and inflation is near zero.

The Bank of Canada’s ‘modest’ target

The Bank of Canada aims to keep inflation at the 2% midpoint of an inflation-control target range of 1% to 3%. The inflation target is expressed as the year-over-year increase in the total consumer price index (CPI) – the most relevant measure of the cost of living for most Canadians. The BoC even has a handy “inflation calculator” that lets you see how much your purchasing power will erode over a given period at a given rate of inflation.

The most recent consumer price index statistics from Statistics Canada showed that Canadian all-items inflation rose at an annual rate of 1.1% in February. This means that the cost of goods is rising at 1.1% annually, so your investments must be earning at least 1.1% just to break even on your purchasing power – in other words, just to stay in the same place. Any real growth would imply a return over and above that 1.1% (and remember, this was for February).

Since 2004, inflation has averaged around 2% annually, pretty much spot on the Bank of Canada’s target. Now, 2% doesn’t sound like much, and it isn’t if it’s the return you’ve been getting on a GIC. But consider the damage it does to your purchasing power over 10 years. Using the Bank of Canada’s own inflation investment calculator (just so you know I’m not making this up), I calculated the 10-year future value of a $100,000 investment at a realistic average 5% annual return. With inflation set to “zero,” the investment would grow to $162,889 in 10 years. Not bad.

How inflation eats up investment returns

But with inflation set to 2% (remember, this is the Bank of Canada’s stated target), the real future value of that investment would be $133,626. In my own practice, to be realistic, I use an expected minimum inflation rate of 2.5% to calculate potential investment return targets. Using that inflation assumption, the after-inflation future value of our hypothetical investment would be an even lower $127,249.

You can see that even an apparently “modest” 2.5% rate of inflation can slash the longer-term return on your investment portfolio. Add in the effect of taxes on a non-tax-efficient portfolio and you’d be just about standing still.

Recovering the angels’ share

When discussing expected longer-term returns with your financial advisor, then, always factor in the loss in purchasing power from inflation. If you expect, say, a 5% average annual return, lop off 2% immediately as the “angels’ share” – the loss in purchasing power that evaporates into thin air, leaving you with only a 3% average annual return. To get that 5% real return, you’d have to aim for something closer to a nominal 8% long-term return.

And to do that, you’ll have to carefully allocate assets, diversifying among those that have historically proven to beat inflation (equities, for example), while staying within your defined risk-tolerance boundaries. It’s a challenge, and for most investors it’s a barrel full of complexity. So talk to your advisor instead. That’s what you pay her to do! She’ll be able to explain how various asset classes have performed historically after inflation, and how to build a portfolio that recovers the angels’ share.

© 2014 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited.

© 2021 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.

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