Flickr! photo by jenn_jenn.

Beating inflation at 6+% is difficult

Beating inflation is not easy when it is at 6%+. The unending news about price increases in basic necessities such as flour, rice, transport, groceries, rental etc. in the last year or so means that our investments or savings that are generating a return of 1%+ is actually losing its ability to buy us stuff to feed our stomachs, pay the bills and for recreation. If you earn 1%, you effectively lose 5% of the purchasing power at an inflation rate of 6%.

If you have tried investing your own monies and tasted investment losses besides gains, you will start to realise that the number one rule in investing, i.e. not to lose money rings true for many of us. Why is this?

Losing your capital is BAD!

You know that investing in instruments riskier than fixed deposits, savings and treasury bills exposes you to risk of capital losses. You also know that staying safe in deposits and treasury bills at 1% per annum will still lose you 5% in purchasing power. However, this is the lesser of two evils compared to losing your investment capital in realised losses.

My experience in investing in stocks and shares allowed me to learn through actual realised losses that you can potentially lose 20-30% of your capital if you bought stocks in anticipation of capital gains but losing out in capital losses when the market moved against you when the share price fell after your purchase.

Investing in stocks directly is not for everyone. You should only do so if you are interested about stocks and shares and about the company. There is a real risk of capital losses if you do not have sufficient holding power but there is also the real opportunity of capital gains should the market move up or good news about the company’s earnings and growth appear.

Let’s take an example of Mr. Randy Risk and Mr. Super Safe. Let’s assume both have investment capital of $50,000. Mr. Randy Risk invests in blue chips (80% of portfolio) and in speculative stocks (20%) while Mr. Super Safe pumps all his monies in fixed deposits giving him 1.3%. Assuming the returns Mr. Randy Risk gets from his blue chips are 8% but loses 40% value in his speculative stocks, his returns after 1 year are:

80% of $50,000 x 8% + 20% of $50,000 x -40%

= $3,200 - $4,000

= -$800 or -1.6%

Mr. Super Safe on the other hand makes $50,000 x 1.3% = $650 or 1.3% return.

At the end of year 1, Mr. Randy Risk’s portfolio is down to $49,200 while Mr. Super Safe is up to $50,650. For year 2, Mr Super Safe’s $50,650 generates another 1.3% to $51,308.45 while Mr. Randy has to generate a return of 4.28% in order to catch up with Mr. Super Safe. This is because compound interest allows Mr. Super Safe to grow his portfolio whilst Mr. Randy Risk’s losses eat into his investible capital and requires a higher rate of return to overcome the losses.

Some of you will say that if I play around with the figures, I can show that Mr. Randy Risk can overtake Mr. Super Safe. You are right. The point I am making is not so much the figures themselves but rather that when you have capital losses, you are worst off than if you have put the money aside in a safe instrument and used the power of compound interest to grow your investment capital slowly but surely.

There is no perfect investment strategy

Investing is very much a personal choice. You choose to be Mr. Randy Risk or Mr. Super Safe or someone who is in between the two of them based on your own investment objectives, financial situation and lifestyle. Investing is a very personal activity what even if you choose to be Mr. Super Safe, you should empower yourself to read up more and learn about investments in general.

One of the investment books I read taught me a valuable lesson, that you investment approach should also be dependent on how interested you are in investments and the amount of time, energy and effort you want to devote to your investments. If you do not want to be bogged down and have no interest, a strategy similar to Mr. Super Safe’s may be suitable. If you are interested in investments and find that it is a hobby you enjoy, then you may consider adopting Mr. Randy Risk’s approach subject to your own risk appetite and investment knowledge to invest in equities and other riskier investments.

At the end of the day, choosing one approach is better than leaving your monies in a savings account earning 0.25% per annum.

Be well and prosper.