The impact of inflation and managing investment risk

WHEN deciding how to invest, it’s important to take into account the impact of inflation.

People usually associate investing with making a choice to invest in a certain company or deciding to put money in the bank.

However, inflation is something that happens no matter what investors do and it’s important to understand how it can quietly undermine returns on solid, risk-averse investments.

Australia’s inflation rate for the quarter ending June 2017 was 1.9 per cent (annualised).

While this might not seem much, it has a big effect on the return on defensive asset classes such as cash and fixed income, which are designed to be less volatile over the short-term (hence less risky).

For example, if an investment in a bank deposit yields a return of 2.8 per cent over a 12-month period, an inflation rate of 1.9 per cent would result in a real rate of return of just 0.9 per cent.

That is a low return for any investor, much less a retiree reliant on an income stream from retirement savings.

To mitigate the negative effects of inflation, investors may consider growth assets, which provide higher returns over the long-term, but inherently carry more risk because of potential volatility in the short-term.

The level of risk an investor takes must be carefully managed in line with their risk appetite, age and financial situation.

A younger investor with two, three or four decades ahead of them before retirement will generally have a much greater appetite for risk than an older investor.

This is because they usually have a consistent income stream from their job and are not reliant on investment income.

They also have the investment horizon to recover from a setback, such as a regional or global financial crisis.

While investing in growth assets, such as shares and managed funds, might seem risky in the short-term, in the long-term they can provide significantly greater returns than defensive and less volatile assets.

Peer research published by fund manager Vanguard showed a $10,000 investment in cash in 1986 would have grown to approximately $75,000 by 2016, for an average annual growth rate of 6.9 per cent.

However, that same investment in Australian shares would have grown to more than $150,000 with an average annual growth rate of 9.6 per cent.

This is despite the roller coaster ride of global markets during the dot com crash and the global financial crisis.

Investors can manage risk in their portfolios by diversifying across a range of asset classes and geographies.

Stocking your portfolio with growth assets allow investors to take advantage of the higher-returns on offer, with an accompanying defensive asset allocation providing stability and an income stream that can provide a cushion in inevitable market downturns.

Some investors manage risk through what is called life-stage mix options.

As investors get older, their risk threshold generally declines. In response, life-stage investors choose to have a lower allocation of growth assets and increased exposure to defensive ones in their portfolios as they age.

As each decade passes, they adjust their portfolio mix again according to their lowering risk appetite and how close they are to needing to use retirement money for income.

However, this approach is not for everyone, as every investor’s needs and situation are different.

The best approach in managing inflation and investment risk is to ask an expert, such as a financial planner, on how to stay ahead and have peace of mind.

To find out more, phone MyState Wealth Management financial planner Lonnie Weeks on 1300 651 600.

Information is current as at 23 October 2017. This is general advice only and does not take into account your personal objectives, financial situation or needs and you should consider whether it is appropriate for you.