Inflation has always been with us
The steady increase in the prices of most goods never ceases. Governments in most of the advanced democracies have taken admirable steps to reduce inflation to a low level, but they all accept that there will always be some price growth. The Reserve Bank of Australia targets 2-3% inflation, but does not try to achieve zero price growth.
The RBA and the world's other central banks have all recognized that while it's important to keep inflation low, it's more important to make sure that there's always at least some inflation as modern economies have come to depend on a bit of inflation to keep everything moving.
In deflationary times (in which prices are generally decreasing) economies grind to a halt. If you expect that cars, refrigerators, and building materials will be cheaper next year, you're more likely to delay purchases of all of these things. As soon as a few people hold this belief, their behavior causes it to come true: people stop buying; prices drop; people expect prices to drop farther, and deflation takes hold.
You need to inflation proof your income from your investments. The best way to do this is through investing in companies which will continue to grow their dividends over time. Cash is safe but over time due to inflation it will quickly disappear and your standard of living will fall.
If you want to retire with $50,000 annual income (in today’s dollars) this nominal amount will have to increase a bit each year to keep up with the cost of the things you buy.
Investing in cash
From 1990 until 2016 the average cash rate was 4.9%; we will use 5% for this example.
Some people think that all they have to do is accumulate $1,000,000 and put it on deposit to produce a $50,000 annual income.
If you did this, you would indeed get around $50,000 income the first year. But after a few years, the purchasing power of that income would diminish dramatically. With inflation running at just 3%, the purchasing power of $50,000 income will be reduced by 26% in just ten years. Your $50,000 would be worth only about $37,000. That would make a real difference to your lifestyle! After 20 years, the value would be reduced by 45%, to about $27,500.
Look at it this way. On a $100,000 deposit paying 5% you would receive $5,000 annual income. The Tax Office regards all $5,000 as taxable income. If you’re on a tax rate of 32% (40% tax plus 2% Medicare levy), here’s what happens to the income from your $100,000 term deposit:
Annual interest income: +$5,000
Less: tax at 32% -$1,600
Less: inflation cost -$3,000
Real annual return to you: $400
This means that the real return to someone on the 30% tax rate is about 0.4% per annum.
This doesn’t mean you should never use term deposits. If, for example, you have a bill to pay between three months and two years in the future, a term deposit can make sense, as it will guarantee that you have the cash required when it comes due.
With only very rare exceptions, however, term deposits should never be one of your main investment vehicles.
Your dividends grow faster than inflation
Listed companies are always working to become more productive and more profitable. This constantly increasing profitability allows companies to increase their dividends.
The key point: dividend income from a sensible, reasonably diversified portfolio grows faster than inflation. This doesn’t mean that every company’s dividend increases every year. Some years are good for banking and insurance company profits (and dividends), for example, while other years will be better for resources or technology companies.
Once your portfolio produces enough income to meet your living expenses, you can expect to feel a little bit better off year after year.
If you pick companies whose earnings and dividends grow strongly, you can be miles ahead of inflation. Over the twenty six years from 1990 to 2016, for example, the Consumer Price Index (CPI) increased by about 85%. This means that a collection of goods and services a typical person would buy for $100 in 1990 would have cost about $185 in 2016
Let’s look at the dividends from some major companies over the same period:
Company div/share div/share change
BHP Ltd 36.5c $1.09 +194%
National Australia Bank Ltd 51.0c $1.98 +288%
Rio Tinto Limited 58.0c $2.96 +410%
CSL Limited 10.0c $1.71 +1600%
Westpac Banking Corp. Ltd 52.5c $1.88 +258%
Woolworths Limited 12.0c $1.16 +866%
If you invested $100,000 into the above shares, your income would have started at $8244 p.a. and grew 326% to $35,162 p.a. Not only has your income maintained pace with inflation it has grown close to four times more than inflation.
Yes you are now better off than before. Starting to see why cash is not as safe as you think. On top of this the original $100,000 is now worth $556,000, that is right is has grown 456% in capital value over this time.
The owner of this portfolio has gone from being comfortable to being extremely well funded. From experience, however, I can tell you which topic most clients in this situation would bring up most often will be about the company which failed! The important point is this: good portfolios, even great portfolios, always have a few stocks which will turn out to be dogs. You deal with this by selecting stocks as carefully as you can and by learning to let the dogs go.
If you were to select a diversified portfolio of ten companies right now, all of which have a positive outlook, the likely outcome after ten years is this:
Winners: one or two will have rocketed ahead, with both fast dividend growth and fast share price growth. You’ll wish you had put all of your money in these.
Steady performers: five to seven will deliver dividends which grow much faster than inflation.
Dogs: one or two will lag behind, with declining dividends and share prices.
All you’re trying to do (and all you can expect from a good advisor) is to pick one or two extra winners or avoid one or two dogs. This is all it takes to boost your results dramatically.
Inflation makes life more expensive, if your income is not keeping you then you are getting poorer each day. A well-managed portfolio can ensure not only that you do not fall behind but that you also beat inflation.