Thu. Oct 17th, 2019

DIY financial investing: The monster under the bed

unemployment rate stats saThis is the next instalment in a series of DIY approaches to investing one’s own money.

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Yes, grown-ups
also have a monster under the bed, it is called inflation! And people
love telling scary stories about this monster. Sometimes it tells of how hard
life used to be, sometimes it explains how hard life is now!

“You youngsters have it easy. My first salary, thirty years ago, was only R712. Can you imagine that!”

“Life is very expensive these days. I used to buy a loaf of bread for one Rand, and still had change for toffees.”

“I don’t know what the world is coming to! The Rand used to be stronger than the dollar, but today you have to pay R 14,60 for one dollar.”

The inflation illusion

But, of course, the monster under the bed is only an illusion. Inflation is the phenomenon that larger amounts of money represent the same value, as time passes. In effect, it is simply a renaming of value. To work for an hour, to receive a hundred Rand, and then to buy a jacket for a hundred Rand is, after all, the same as receiving a thousand Rand for the job, but having to pay a thousand Rand for the same jacket.

Current economic theory dictates that a country should have an inflation rate which is higher than zero, but not too high. In South Africa, the Reserve Bank adjusts interest rates with the aim of keeping our inflation rate between 3 and 6%. The latest inflation data, which came out last week, is 4,4% and just what we want.

In the United States, they aim for an inflation rate of about 2%. The fact that the value of our currency changes faster than theirs means that the exchange rate will change over time in line with the difference in inflation rates.

If no other political or economic factors came into play, one would estimate that the Rand would fall by 2,4% against the dollar over the next year. Fortunately, this does not mean that an overseas holiday will be more expensive in real terms next year because salaries generally also increase in line with inflation.

As an investor, one should always be aware of inflation, so as not to delude yourself into thinking that something is an investment when it really is not.

Also read: What is a financial investment?

Here are two
scenarios to avoid:

  1. Do not leave a significant amount of money in an account where the interest rate is below inflation. By putting R100 000 away for a year at 4% when inflation is 5% you are effectively poorer at the end of the year, even though you have R4000 more in your account.
  2. Be careful not to use all the interest from an investment. If you have R100 000 in an account that earns 9%, and you use the full R9 000 every year, your investment amount remains R100 000. But after a few years, R 100 000 will not be a lot of money any more, because it decreased by inflation every year. The best strategy is to reinvest a part of the interest, say R5 000 so that the real size of the investment stays the same.

Next week we look at options for interest-bearing investments which beat inflation.

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