Financial Plan: Does Inflation Affect Decisions on Where to Invest?

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May 31, 2014 / TheAnalyst
 

Financial plan in general perspective represents the mapped out strategy or line of action of an individual or corporate business body to accomplish a financial goal or objective such as elimination of debt, retirement preparedness, risk management, etc.
 

In addition, the plan often includes a financial statement which organizes an individual's finances and sometimes includes a series of steps or specific goals for spending and future savings.
 

Inflation, a financial fact out of one’s control, is a monster that has the potency to reduce the purchasing power of money and eats into your hard earned savings, must be put into account when a financial plan is being drawn up particularly for retirement, as it usually have adverse effect on investment plans.
 

Normally, higher inflation as well as expectation of higher inflation leads to higher interest rates which simply mean lower bond values and weaker stock prices. Hence, the need to be aware of inflation trends as well as factor a realistic expectation by taking steps to protect one’s finances just in case the inflation rate rises.
 

As many of us may be aware, the CPI Inflation data for April 2014 stands at 7.9%. The figure has been in single digit for the 16th consecutive month after it moved from 12% in December 2012 to 9% in January 2013.



 

Inflation can be a devil if you do not handle your finances prudently. The detrimental impact of high inflation is that it reduces the purchasing power of money and eats into your hard earned savings. You may have witnessed that today, with N100 in your pocket you can buy fewer goods and services than you could buy probably about a decade ago.

 

That is because the value of your hard earned money and savings does not remain constant; it reduces as inflation eats into your hard money and even what you have saved. So, day after day, your savings may lose their worth, making them incapable of attaining your financial goals.

 

Let us understand with the help of an illustration: Mr Tolu Ajayi has a 6 year old son. He wishes to send him to a good college for graduation when he turns 18. Today, the cost for graduation is about N1 million. Assuming inflation rate at 10% for education fees, the college fees would cost N3.14 million after 12 years. That is the effect inflation has on expenses.

 

Inflation needs to be taken into account while planning for not only education but also retirement, holiday, wedding, medical etc.
 

An excessively conservative investor, who has not accounted for inflation while constructing his financial plans, might be the worst hit from its impact. This might be more applicable if he has been investing only in savings account or fixed deposit, which have failed to provide high inflation-adjusted returns. There are certain asset classes such as Equities and Real Estate that enable you to fight the inflation bug over the long-term.
 

Equities over the long-term are one of the best to beat the inflation bug, as they can yield effective inflation-adjusted returns. To invest in equity, you could either opt for direct equity investment i.e. through stocks or invest through equity mutual funds.
 

Both have their own advantages and disadvantages. If an investor has profound insights about stocks and investing, with the necessary time and skill to analyse companies, then he can surely begin independent stock-picking.
 

However, in case you lack any one or all these pre-requisites, then you will be better-off investing in stocks through equity mutual funds, since they offer several important advantages over direct stock-picking, some of which include:
 

  Superior diversification  

   Professional management  

  Economies of scale  

  Lower entry level  

Liquidity

Innovative plans/ services for investors
 

Irrespective of this advantages that come with investing in mutual funds, care should also be taken in order to select winning mutual funds which most times are the diversified equity funds over sector/thematic funds.
 

Property is again a preferred avenue of investment as during inflationary times, property prices too tend to escalate in line with the increase in cost of construction. The only deterrent here is that the minimum amount you need to invest here is substantial and beyond the reach of most investors.
 

Nonetheless, the past trend in prices suggest that investment in real estate or property has been quite rewarding, and can be considered by one as an "alternative investment" in your overall investment portfolio.
 

One can also look at investing in gold to counter inflation over the long-term as it has delivered good returns over time. When uncertainty has bothered global markets; the precious yellow metal has done well as smart investors take refuge under it in times of uncertainty.
 

But it is noteworthy that gold generally tends to perform inversely vis-a-vis equities in times of risk-on and risk-offs. While investing in gold, one can either buy physical gold or invest in Gold Exchange Traded Funds or gold savings funds.

 

 

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