Thursday, January 20, 2011

Volume 3 Issue 3: Intelligent Investing

Investing in Inflation - Part 1

How is this even possible? In this two-parter, I will discuss on how one can invest in such a way that you are "protected" from inflation. Before that, let us first recap and discuss what inflation means and how it affects us.

In the most common of terms, inflation is defined to be a consistent increase in the general price level of goods and services within an economy. If this still sounds too complicated, just think about the price of a cup of Milo at your favorite coffee shop five years ago. It would probably have cost you RM1.00. Today, it is quite likely to cost closer to RM1.50 or RM2.00. That is how inflation is observed in one good. But if only the price of Milo is rising, then it is OK because we can simply switch to other beverages if we decide not to pay too much for Milo. So it is insufficient to label the increase of the price of Milo as inflation.

As I mentioned, inflation is the consistent rise in the general price level. That means that most of the commonly used goods and services are becoming more expensive year after year. It is also insufficient to label price hikes due to certain natural disasters such as floods or earthquakes under the category of inflation. Inflation is reflected in the consistent rise in prices. It does not count when prices go up for 3 months, and then fall back down to the normal level. Inflation is when prices keep going up and up.

Now that we are clear what inflation is, how does it affect us? Most people on the Main Street choose to save their money in the bank. The more careful ones would even place their money into fixed deposits to get a higher rate of return. Let us first consider the simplest of cases. Jim keeps all his savings under his pillow, where he earns zero returns. In the past 10 years, the inflation rate has averaged around 2.2%. This means that prices of goods and services have gone up at around 2.2% per year for the past 10 years. So if Jim were to have saved RM1,000 under his pillow at the start of 2001, the purchasing power of that same RM1,000 would be equivalent to that of RM815.28 today. He can buy much less with the RM1,000 than he could 10 years ago.

Clearly, from this example alone, we can see that inflation erodes the value of our money. What happens when we place our money into fixed deposits? Now, consider Sam, who placed his RM1,000 into a fixed deposit account in a Malaysian bank at the beginning of 2001, and reinvests the capital plus interest at the beginning of each year at the prevailing rate. At the end of 2010, Sam would have saved up RM1,427.99. What a difference this makes compared with Jim who did not put his money into any kind of interest-bearing vehicle.

Let us now factor in inflation. At the average of 2.2% per year inflation rate, the purchasing power of the RM1,427.99 is equivalent to that of RM1,164.21. Imagine that! After 10 long years of saving his money in fixed deposit, Sam has managed to attain a real (inflation adjusted) return of 16.4%, which translates to roughly 1.5% per  annum. I don't need to elaborate further how sad the returns of fixed deposit are.

What makes things worse is that, the only reason Sam is making a positive return is because Malaysia is a highly subsidized country. This means that a lot of the prices of goods are controlled by the government, such as fuel, electricity, water, flour, sugar, cooking oil, fertilizers, etc. Hence, in actual fact, prices of goods around the world have risen at a much faster rate to much higher levels.

Just imagine if the general price level had risen at the same rate as that of the World's Consumer Price Index. The average inflation rate of the whole world in the past 10 years is about 3.9%. This is how much the Malaysian government has distorted the prices of goods and services in Malaysia. But that is another story for another day.

Now, let us recalculate Sam's purchasing power after 10 years after adjusting for the world's inflation rate. After 10 long years of saving in fixed deposits, the purchasing power of Sam's RM1,000 in 2001 will be equivalent to RM976.18 today, which is LESS than what he started with.

How is this even possible? Well, this was made possible by the simple fact that on average, the inflation rate exceeded the interest rate offered by the banks. Given that Malaysia is trying to cut all the subsidies that it possibly can, this is going to be what saving your money in fixed deposits will look like in the next 10 years.

It has been clearly illustrated that inflation can be one of the greatest enemies of investing. It will erode your purchasing power, whether you like it or not. In the great words of one of my friends, "Putting your money in fixed deposits is a way of getting poorer slowly, but surely". This makes it even more important to learn how to invest. We will discuss our options in beating inflation in the next part.

1 comment:

  1. One simplified yet extremely insightful on inflation AND how our inflation rates are continually kept low by government subsidies.

    It is a sad thing for Malaysians,
    but i would like to add to this depressing revelation.

    In light of the recent gains our Malaysian Ringgit has against the US dollar, I would like to emphasize that our Ringgit has depreciated against other countries such as the Swiss Francs ,the Australian Dollar and other currencies etc.

    Calculating the fact that heavy investment flows are entering to the NEIGHBORING countries such as Indonesia, Thailand, and Philippines who are more competitive and have achieved higher growth in their GDP in recent years, with heavy government investment and subsidizing in potential growth industries, Malaysia is 2nd choice for foreign investors.

    What happens here is that as our industries lose their relative competitiveness, due to over reliance to commodities and under-specialized, non-heavy industries, our economy will suffer a slowdown. Coupled with the fact that our currency is depreciating,it is a dim outlook for me of the Malaysian economy. In certain markets whereby currencies depreciate, usually their stock markets enjoy an inflow of foreign investment(etc USA & Germany). Sadly, this is unlikely to happen to Malaysia, and all that can be said is.

    Perhaps investing in FD is not the only knack, sadly holding your money in Ringgit could lead to you having the best Double Slap in your life in the coming years. Run, and run far.!