YOU want to grow your money, but are worried that you may lose what you have worked so hard to earn? If so, you have lots of company in this Catch-22 situation.
Most of us realise that if we don’t invest our money, it will continue to lose its value and we will ultimately fail to meet our financial goals. On the other hand, we may fear getting burnt by poor investment decisions due to perceptions about investing or previous bad experiences.
Therefore, in order to optimise our wealth, we need to find the middle ground between these extremes and put our money to work for us. But first, you need to get to grips with the potential risks and their source.
Today, anxiety about the eroding value of money is growing as accelerating inflation appears to be our constant companion, driven by both external and internal factors.
Over the last several years, we have become familiar with the concept of quantitative easing (QE), which is one form of external stimuli that can fuel inflation. QE is an unconventional monetary policy that is used by central banks to stimulate the economy when the usual medicine is not working.
In short, QE is where the central bank creates money electronically and buys financial assets such as bonds to pump money into a sinking economy. While this may help prevent businesses from going bust, it can also cause prices to soar if too much money is in circulation.
Since the global financial crisis of 2008, a number of developed economies have injected trillions of dollars into the financial system through rounds of QE. With so much money pumped into the world economy and interest rates kept super low, money has found its way into all sorts of asset classes, including commodities. As a result, prices of commodities like oil and gold have hit spectacular heights. But how do higher commodity prices affect each and every Malaysian? Well, when the prices of raw materials are inflated, producers of consumer products will face higher production costs, which are passed on to consumers.
Internal factors that affect inflation include, for example, the removal of subsidies. When this happens, as many Malaysians are finding out, the prices of consumer goods will rise. In this country, the government subsidises a whole host of essentials such as cooking oil, sugar, flour and fuel. Naturally, such subsidies come at a price – in our case it makes it difficult for the government to live within its means.
No doubt inflation is a problem and leaves us with little choice but to invest our money. Nevertheless, when we invest, we also inadvertently expose ourselves to the risk of making investment losses. The long list of investment scams like the notorious Madoff affair leaves investors wary of even the most reputable and well-regulated institutions. Until recently, many of us thought the banking system was an elite brethren of maestros – yet how times have changed. During the 2008 crisis, many unit trust funds lost 30% to 40% of their value, and investors took the hit.
The risks are higher in unregulated sectors such as land banking schemes in the UK and US and gold bullion schemes where the investor is unprotected when the value of his investments collapse.
The problem is only compounded by the wide variety of investment choices that are available for those who choose to step out from the safe sanctity of fixed deposits. Property, a traditional favourite, is holding its own, but the big question remains – how long will the good times last?
How inflation cripples your financial freedom
For the layman, inflation basically means that the prices of goods and services keep going up. According to the official statistics, our Consumer Price Index (CPI) is around 2%. However, most of us actually experience a higher inflation rate than that because we consume a lot of items which are not counted in the CPI. I estimate the inflation rate to be 4% to 6%, depending on the items you actually purchase.
Table 1 illustrates a very simple example of the impact of inflation using a 6% average increase in the cost of living and a 4% annual investment return.
Let’s look at the Capital column first. Note that if we start with RM3mil in capital and inflation averages at 6% annually, it takes only about 12 years for the value of the wealth, in today’s ringgit, to decline by 50%. In other words, if you took RM3mil and buried it in your garden, then went back and dug it up 12 years later, assuming the average inflation rate was 6% during the 12 years, your money would be worth only half as much as in current ringgit as when you buried it. And every 12 years thereafter, its value would likewise be reduced in half. So, this is the first negative impact of inflation – it destroys capital. Now, let’s look at the Income column and at the impact of 6% inflation on your investment income over time. A 4% return on RM3mil invested would yield RM120,000 annually. But at the same 6% inflation rate, the purchasing power of that income in 12 years would be only half as much as it is today.
For example, if you buy a cup of coffee for RM1.30 today, it will cost you double (RM2.60) to buy the same cup of coffee 12 years from now. Effectively, your RM120,000 income can only give you half of the current purchasing power 12 years later. A further 12 years, the purchasing power would have reduced by half once more. After 36 years, the investor would need to get by on one-eighth of the purchasing power with which he had started. As this example shows, inflation is a very serious problem.
The impact of losing your accumulated money
Psychological studies show that we feel the pain of a dollar lost twice as much as a dollar won. Obviously, none of us enjoy losing our investment capital. Table 2 helps us understand why.
Let’s assume Ahmad has invested a sum of money and is trying to achieve a 10% annual compounded return every year for the next five years. , If Ahmad loses 10% of his principal sum in the first year, he would need to achieve a return of 16% for the next four years to equal the original target of 10% for a five-year period. If he were to lose 40% of his principal in the first year, he would need to achieve 28% annualised return for the next four years to equal the original target.
As the example above illustrates, the bigger the loss on our principal capital, the higher the return on investment (ROI) we will need to generate in order to achieve our original investment target. To achieve a higher return on investment, we would need to take more risks. In short, the careless loss of current created wealth would definitely make our investment job tougher. Now we can understand better why Warren Buffett’s No. 1 rule in investing is “Never lose your money.”
Striking a balance
As you can see by now, investing involves making decisions as to where to place our money: On one end is to avoid inflation risk and another to avoid the risk of losing capital. To avoid inflation risk, one may choose to invest in high return, high risk investments such as equities. To avoid risk of losing capital, one may choose to invest in low risk, low return investments like fixed deposits. However, the ideal choice is to strike a balance by growing the investment above the rate of inflation whilst protecting our capital at the same time.
So, where are you on the scale? Do you find yourself keeping too much in savings or rather, are you exposing yourself too much to potential capital loss?
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