Two months ago, I was discussing investments with my banker, and the options I had available in this age of low rates. He casually mentioned one of his new bank products: a bond in Singapore Dollars that would offer 2.5% yearly. I reminded him that Singapore’s inflation was over 3%… in other words, I would actually loose money by investing in the bond!
It is interesting that a lot of, if not most, people do not think of inflation when considering investments and savings. This is a big mistake as in my previous anecdote, it can turn a profitable investment into a loosing one. It is a mistake encouraged by the whole financial industry as most performance numbers (stock index, fund performance, etc.) are given in nominal currency rather than inflation adjusted, making the numbers look bigger than they really are. Regular people will do this too, claiming they have made “this much money” by buying a house 30 years ago for pennies and selling it today. Yes, but how much are those pennies worth in today dollars?
Some investments are “inflation proof” while others are not:
- Fixed rate bonds and time deposits are not protected against inflation. If the yield, after taxes, goes below inflation then you are just loosing money – more exactly earning money yet loosing wealth. There are many types of bonds, some of them offering a protection of some sort (by indexing on some benchmark rate or even on inflation itself).
- Commodities (gold, oil, wheat, etc.) are of course inflation protected since they are actually some of the products whose price increase is measured as inflation. The problem with commodities is that they produce no income and only offer potential profits by speculating. (i.e.: buy low, sell high)
- Real estate is, like commodities, a form of “hard assets”. (a house is made of materials, and if prices of materials go up then so should the house) While the real estate market is cyclical, over the long term prices follow purchasing power and as such beat inflation.
- Stocks are also inflation protected: there’s some debate over how good or bad the stock market performs during high inflation times, but it cannot be denied that shares represent a slice of a company’s assets (factories, offices, machines, brands, etc.) whose value will go up with inflation. Also companies actually participate in forming inflation by raising their prices: this in turn raise their income and earnings.
Hence when comparing a stock that delivers a regular 5% dividend and a simple bond from the same company paying that same 5%, it should be considered that, all other things being equal, the stock is likely to increase its value and dividend with inflation, whereas the bond will still pay the same coupon and be repayed the same nominal at maturity. (there are of course other things to consider before choosing one or the other)
As a side note, most tax systems in the world do not account for inflation. So if your investments yields 4%, is taxed at 25% and inflation is 3%, you actually gain 3% after taxes, which is 0% once inflation is deducted. It would be more fair to let taxpayers deduct inflation first and pay taxes on what is left, as this is the real profit being made. (in this example the taxpayer would be left with 0.75% which is still better than literally nothing)