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Inflation is often mentioned in terms of financial plans and financial planning. In risk management, inflation risk and purchasing power risk are agents that mitigate the value of your investments and income. How inflation should be utilised is highly debatable. The issues concerning inflation’s use are:

1)How it should be projected
2)Which measure should be used
3)Implications for financial returns

1) How inflation should be projected

There’s a maxim that past performance should be a guide to future performance. This does not necessarily apply to inflation. In using an inflation projection, an average measure must be used over an investment period. This average should be based on current inflation rates and the monetary and fiscal policies of government or a central bank. If the current inflation rate is 3%, then a projection could be based on this once the inflationary environment is stable. If the inflationary environment is volatile, then projections are more difficult. In economies where inflation-curbing methods are taking effect, it may be alright to use a lower future inflation rate than the current rate.

2) The measure of inflation that should be used

Inflation can be classified as headline inflation or core inflation. Core inflation discounts the impact of food prices on the headline inflation rate. It is therefore lower than headline inflation. The Consumer Price Index (CPI) is the discounted factor in core inflation that should be used from a financial planning perspective. This is because the CPI is a direct measure of the goods and services purchased by individuals. However, even the CPI is only an approximate measure for an individual’s financial plan. The expenditure of each household will differ significantly. The expenditure patterns of a household would determine how the increase in costs of the goods and services directly affects them. The CPI is merely a guide.

3) Implications for financial returns

That inflation reduces the real return on investment is old news. However, the inflationary environment would have an impact on after-inflation returns and performance of certain equities. There are certain investment instruments that thrive in inflationary environments, like gold and real estate. Alternatively, bonds, fixed investments and money-market funds tend to do badly in high inflationary environments. Since there is a correlation between risk and returns, stable inflation generally produces lower nominal returns. The factors that should be analysed should be both the real rate of return and the economic environment.

Inflation is the main reason why financial advisors suggest that investments must be diversified. The main reason for this advice is that the higher returns from growth and income instruments would mitigate the impact inflation risk and purchasing power risk. Even though there may be some disagreement about how inflation should be applied in projecting returns and constructing financial plans, it is important to guard against its corrosive effects on savings and investments.

Darrell Victor is a financial services sales professional who specialises in retirement planning and insurance advice. To read his latest articles visit http://www.helium.com/user/show_articles/338815

Article Author :Darrell_Victor

Tags: investments, insurance

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