The real impact of inflation

Inflation is a slow force working against your financial goals. It can quietly erode the purchasing power of your money over time. While it’s tempting to see cash as a safe haven, failing to factor in inflation could mean your savings are worth less when you need them most.

So, let’s dive into the showdown between inflation and your savings, and explore strategies to fight back!

Inflation erodes cash returns

The Reserve Bank of Australia (RBA) defines inflation as “an increase in the level of prices of the goods and services that households typically buy”.

When inflation goes up, the value of each dollar you own decreases, meaning you can buy less with the same amount of money. This becomes a real concern for investors who rely on cash or low-risk investments like term deposits, where returns may not keep up with the rate of inflation. For instance, if you’ve placed your money in a term deposit earning 5% interest, but inflation is running at 6%, you’re effectively losing 1% of purchasing power. This is what’s known as the real return – the return on your investment after adjusting for inflation. A return of 5% may look good on paper, but in real terms it means you’re going backwards.

How could you prevent inflation from chipping away at your savings?

One effective approach is to adopt a diversified investment strategy. Diversification involves spreading your investments across various asset classes such as shares, property, bonds, and international assets, rather than keeping all your money in cash or low-risk products.

Equities (shares), for example, have historically outpaced inflation over the long term. While shares can be volatile in the short run, their potential for higher returns helps them beat inflation over time. Property investments also have a history of delivering inflation-beating returns, as the value of real estate typically rises along with inflation. Exchange Traded Funds (ETF) may be another simple and low-cost way to diversify your investments.

A well-diversified portfolio ensures you’re not overexposed to any single asset class. Instead, you benefit from the potential growth of various sectors, reducing your overall risk and improving your chances of keeping pace with or even outpacing inflation.

Practical advice for investors

Investing during inflationary times can feel overwhelming, but there are several steps you can take to safeguard your wealth:

• Stay informed: Keep an eye on inflation rates and the broader economic environment. This may help you understand how inflation is impacting the real value of your investments.
• Consider inflation-protected assets: such as inflation-protected bonds, resource shares and commodities.
• Review your cash holdings: While cash can serve as a safety net, holding too much in low-interest savings accounts can hurt you in the long run. Consider maintaining an emergency fund (of 3 – 6 months expenses) but limit excess cash holdings in favour of higher-return investments.
• Embrace diversification: A balanced portfolio with a mix of assets can help you spread risk while still allowing for growth that beats inflation.
• Seek professional advice: Financial advisers can provide tailored advice based on your risk tolerance, financial goals, and the current economic environment.

The bottom line

Inflation can negatively impact the value of your savings, particularly if you rely on cash or low-risk investments. Over time, even a modest inflation rate can significantly reduce your purchasing power. By diversifying your investments, staying focused and informed, and seeking professional advice, you can set yourself up to win the battle with inflation.