How to beat inflation

April 26, 2010

KARACHI: One of the simplest and most important concepts to understand when thinking about personal finance and investment strategies is the time value of money.

It is a concept that takes on an even greater importance in Pakistan, owing to the abnormally high rates of inflation in the country. Simply put, it is better to have a fixed amount of money sooner rather than later.

For example, if you had the choice between receiving Rs100,000 now and the exact same amount a year from now, it would be obvious as to which option is better.

It is clearly more advantageous to have the money now rather than later. This seems intuitive enough, except that its implications are not always as clear.

Part of the reason is that most people do not understand why this matters is that we do not deal with hard numbers. Sure, we understand that inflation means that the value of a rupee next year will be less than the value of a rupee today. But exactly how much less? And what do we need to do in order to make sure that the real value of our savings does not diminish over time?

The first question is simple enough to answer

The Federal Bureau of Statistics publishes inflation figures every month and also compiles annual averages. Since 1991, Pakistan’s inflation rate has averaged 9.3% per year.

What this means is that if you did not earn an average return of more than 9.3% per year during that time frame, you essentially lost money. (Average returns are calculated geometrically, not arithmetically. For details on what that means, contact your local mathematics teacher.)

This is why bank deposits are not a good way to accumulate wealth.

For example, inflation this year is expected to be more than 12%. If your term deposit account yielded 8% during that time, did you make money or lose money? If you read the above paragraph carefully, you know that you lost money.

The wrong way to do it

Committee savings, in which households save by pooling their money every month and giving it all to one person, are actually a bad way to raise money for the same reason. Think about it: you save the same amount every month and you have to keep on paying in regardless of when your payout was.

This is the same thing as putting your money in a current account, except that there is a small chance that you might get a bulk payment sooner rather than later.

The actual return you earn on your investment is 0%. And when measured against the impact of inflation, you are actually losing money.

These are not the banks you are looking for

Savings accounts at banks are not good either, with a measly return of 5%. Savings certificates and bonds do slightly better but not by much.

More importantly, they do not really beat inflation.

In fact, only three asset classes actually beat inflation on a long term basis: stocks, oil and gold (in that order).

Dare to be stock-broken

Stocks in Pakistan have returned an average of 21% per year over the last 10 years. Oil (which is difficult to invest in directly and not possible at all to invest in while within Pakistan) returns around 14% per year over the same period and gold returns around 12%.

Is gold an investors best friend?

I would also like to get rid of the myth that gold is somehow a “safe” investment. Gold is traded on global commodity exchanges, much the same way stocks are traded on stock markets.

Moreover, gold prices can be just as volatile. For example, gold prices went from \$715 an ounce to \$570 an ounce in a matter of four months in 2006, one of the many cyclical ups and downs in gold prices throughout its history, much like stocks.

Theres even a conclusion for those that won’t bother to read the whole thing

In short, there is risk in virtually everything. If the rupee amount of your investment remains constant, it only means that the real value (i.e. adjusted for inflation) has gone down.

With stocks and commodities like oil and gold, one’s portfolio moves around a little more, but ultimately ends up doing better over the long run.

Nothing, however, beats stocks in terms of long term returns, which is the most important time horizon one should think about.