Oran Hall Potential hedges against inflation
It is easy to deceive yourself into believing that you are better off because the value of your assets has increased over a given period.
Such an increase can be meaningless, though, if what you can buy at the end of the period is not at least equivalent to what the original sum could have bought. Where there is a loss of purchasing power, the main culprit is inflation.
Inflation is the sustained increase in the general level of the prices of goods and services used by consumers or private households. The rate of inflation is the percentage change in the average price level of a fixed set of goods and services (the CPI basket) in an economy over a given period.
A modest level of inflation is expected in an economy that is growing, and governments are keen to ensure that the rate of inflation does not get too high because of the adverse effects it can have on the cost of living and the pressure it can put on them to provide for the citizenry.
You do not have to experience a loss of purchasing power if you buy assets that have the potential to increase more in value than the rate at which prices increase. It is true that building an investment portfolio that focuses on hedging against inflation by way of investment instruments that appreciate in value, especially over the long term, is an effective strategy.
Often overlooked are assets that are usually acquired for personal use. Included in this group are real estate that is used as a personal residence; art, such as paintings and sculptures, which are used for decoration; rare manuscripts and books; stamps and coins, the collection of which can be a hobby; and jewellery, for personal use. These have one thing in common: they provide enjoyment for the buyer or user.
The ability of most of these to appreciate in value rests with their quality, which is often reflected in their price, so this may rule out some people.
Some people also use currency, especially where their national currency is weak and tends to lose value consistently. One approach used is to buy foreign currency and hold it, but another approach is to buy assets denominated in foreign currency. The value of such assets increases as the local currency loses its value.
While it is true that residential properties are generally held for a long time, we know that some are sold in some circumstance and that the equity in them is sometimes used as collateral to secure funds for productive purposes.
People with deeper pockets or with the willingness to take risk may choose to add a residential property or more to their portfolio. Where borrowed funds are used to acquire such properties, the rental income is generally available to pay most or all of the mortgage while the value of the property appreciates.
Equities, also called ordinary shares, notwithstanding their tendency to lose value from time to time, have proven to be a reliable hedge against inflation in the long term. Short-term market fluctuations may cause prices to decline, but cutting and running is not necessarily the best course to take when the stock market declines as an opportunity may be lost to gain when the market rebounds.
The truth is that assets that have the potential to increase also have the potential to lose value due to general market fluctuations. This includes real estate although we have not seen much of that in our market recently.
Capital growth unit trusts and mutual funds also provide a means to hedge against inflation. They tend to invest in assets like equities and real estate in the Jamaican market. While some may be almost fully equity funds or real estate funds, considering that they are permitted to include cash and interest-earning securities in the portfolio, others may include both.
Life insurance also provides a way to hedge against inflation by way of equity-linked policies. The unitised segregated funds into which a portion of each premium payment is invested, operate like unit trusts and mutual funds, so their unit values may increase or decrease depending on how the prices of the assets of the fund move.
One big advantage of assets that appreciate in value is their favourable tax treatment considering that capital gains is not taxed. This is important because taxes have the potential to reduce the gain on an asset to a level below the rate of inflation, thus giving it a negative real return.
Inflation is indeed a little monster, but it does not have to wreck you financially. With a good investment programme focused on capital growth, you can defeat it if you have the capacity and willingness to take the risk.
Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.