Do you know what your investments are really earning?

Last week’s inflation figures fell back slightly from the previous quarter, but they’re still much higher than the Reserve Bank would like.

The headline consumer price index (CPI) rose at an annual rate of 3.7 per cent, which is some way above its 1-3 per cent target band.

We recently saw a hot inflation print in the US too, with its headline CPI at similar levels to ours.

Audio also available on the Craigs Investment Partners YouTube channel. 

Inflation in both countries has been running above two per cent for more than five years now, and there’s little evidence of a reprieve on the horizon.

It’s not just policymakers, consumers and prospective political leaders who should take note of this.

Investors also need to be very mindful of how inflation can impact their holdings and erode their returns.

Money is only useful if you can exchange it for the goods and services that you need or want.

When you’re investing, what you’re really trying to do is maintain (and hopefully grow) your purchasing power.

Working against you in the background is inflation.

As prices rise, each dollar doesn’t go quite as far as it did before, so you need to make sure your capital grows by at least the rate of inflation just to stand still.

Let’s say you’ve achieved a return of eight per cent over these last 12 months.

It’s not relevant whether we achieved that from property, shares or a diversified fund of some sort, the concept is the same.

That’s the nominal return, and it looks pretty good on the face of it.

The real return (which is adjusted for inflation), on the other hand, is quite a bit less.

Remember we’ve just had confirmation that inflation was 3.7 per cent in this last year.

That means the “real” return from our investment is not eight per cent, but a much less exciting 4.3 per cent.

You’ve got to account for tax too, as well as any fees or expenses.

If we’re talking about a typical managed fund, your eight per cent return probably slips into the high sixes – let’s assume 6.7 per cent.

Take a 3.7 per cent inflation rate off that, and the genuine, real return (after fees, taxes and most importantly inflation) is now a much less impressive three per cent.

It all adds up, doesn’t it?

The impact can be greater for conservative investments, where more of the return is from income rather than capital growth.

That can mean you pay tax on a bigger portion of the return, as income is fully taxable and capital gains are (for the most part) untaxed.

Sign up today for a one-year term deposit paying a four per cent return and it quickly turns into 2.9 per cent, after allowing for the maximum PIE tax rate of 28 per cent.

If inflation remains stubbornly close to current levels over the next 12 months, there’s every chance your true return will end up close to zero, or even slightly negative.

It’s important investors understand the impact this can have and the difference between nominal and real returns.

Those who remember the 1970s and 1980s will appreciate this, as New Zealand inflation averaged 11.7 per cent over those two decades.

In contrast, from 1990 until 2020 the New Zealand inflation rate averaged just two per cent annually.

Several factors contributed to that structural shift, including a focus on inflation targeting from central banks, the emergence of China as a lower-cost global manufacturing hub and numerous technological advances.

Until the COVID-19 pandemic, a large cohort of society hadn’t experienced high inflation so the concept of real returns wasn’t as important.

However, even at low levels, inflation can do a lot of damage to your wealth.

At three per cent, it will still reduce your purchasing power (and the value of your capital) by more than 25 per cent over 10 years.

Right now, the Reserve Bank would love for it to be as low as that.

Instead, the road back to target is proving to be much longer and windier than expected with inflation having averaged 4.4 per cent over the past six years.

That means investors need to appreciate the difference between nominal and real returns, and understand what they’re really earning after inflation has had its say.

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