Anyone who has spoken to their parents or grandparents about the cost of living will be familiar with the idea that the relative value of money has changed over time. Most people are aware that prices for the same object gradually increase, although we often only hear about how this affects the property market. Unfortunately, the cost of living also goes up over time, and this is what inflation does. The value of a dollar today is not worth what it was last year, and this difference increases over time.
To put this in perspective, we need to keep in mind the concept of "real rate of return." This refers to what your investments are really returning for you over time, once inflation has been taken into consideration.
To use a real example, let's look at the history of the Australian share market versus inflation. For the past 30 years, the Australian share market has given an annual return of 8.4%, meaning that a $10,000 investment made 30 years ago would have grown to be worth $113,405 today. By comparison, the rate of inflation we've had over that time has been 3.0%. For investors, the real "take home return" you've had over that time is the difference between the two measures being 5.4%, or that same $10,000 has really grown to $89,374.
So what does this really mean for investors? The only way to reduce the negative impact of inflation is to place a portion of your total investment amount in assets that will also go up in value over time, such as through shares and property. Investing in cash and term deposits, unfortunately, doesn't fit this bill, as the return to the investor only comes from income (interest). To again use the 30-year figures to illustrate this, if an investor placed that same $10,000 investment in cash 30 years ago, the return would have been 6.4% or an increase to $65,127. However, this drops to just 3.4% or $41,096 once inflation is taken into account.
Hopefully, this illustration confirms why the savvy investor needs to take into consideration the negative effects of inflation on real returns. The best way to combat this is to include some exposure to shares and property in your overall mix of assets. Inflation is the "silent killer" of long-term results, so set your allocations right in order to reduce the impact on your overall outcomes.