Nuts and Bolts Part 3: How do you beat inflation?

In both Part 1 and Part 2 we discussed how inflation works, why it’s useful but also when it becomes destructive. Both parts raise a crucial question: if inflation eats into your purchasing power, how do you not only stay ahead of inflation’s impact on your purchasing power but actually meaningfully beat it for your long-term wealth.

What is “beating” inflation

In Australia the Reserve Bank of Australia (RBA) wants core inflation to average 2 to 3 per cent per annum. This is the level the bank believes is the optimal level of inflation to maintain sustainable growth, employment and prosperity. Above or below this band one should expect the RBA to be moving interest rates in an effort to shift inflation back inside this band.

However, 2 to 3 per cent should immediately raise a red flag when you consider what your cash needs to do to maintain your purchasing power.

Even with the moderate level of inflation Australia is currently experiencing this means the money you have at your bank is losing purchasing power. Take the average cash management account in Australia that currently sits at 0.05 per cent. The average 12-month term deposit is 1.0 per cent. The current rate of inflation in Australia is 1.1 per cent. Your cash at bank, although earning interest, is not enough to offset the rate of inflation and you are losing purchasing power.

Thus, to actually beat inflation you need to invest in other assets outside of cash such as equities and fixed income.

Equities over inflation

Investing in equity markets is one way to potentially beat inflation. Whilst it’s easy to point to examples of individual security prices falling, or companies going out of business or even large bear markets depressing indices over a certain period. In the end, the long term total return (capital growth and dividends reinvested) that comes from equity indexes will beat inflation.

For example, here is the ASX 200 versus Australia’s inflation rate over the past 10 years.

As the chart shows, the ASX 200 has suffered downturns over this period but even with these events it is still outperforming inflation by 130 per cent.

Look at it another way - the ASX 200 averages 8 per cent per annum (based on the past 20 years). Australia’s average inflation rate over the same period is 1.9 per cent. That means that equities outperformed inflation by 6.1 per cent per year. When you compound this over several years it’s easy to explain why equities not just beat inflation but grow your wealth.

This isn’t just an Australian scenario. If we look at the US S&P 500 the average total return is 10 per cent per annum over the past 20 years. Again, like Australia it has had years where it has contracted but over the long term the S&P 500 has seen a significant outperformance to inflation.

We should highlight here that investing in individual stocks offers no guarantees. However, a diversified investment in a broad market Exchanged Traded Fund (ETF) can grow wealth over time and beat inflation.

If we adjust for inflation, an investment in an ASX 200 ETF has averaged over 6 per cent return per annum over the past 10 years. The key here is the diversification which smooths out the risks associated with individual holdings.

Fixed Income over inflation

Some will find the market movement of equities too high, therefore we should look at other asset classes such as fixed income, which will offer lower returns than equities but lower volatility too. But even these lower return assets still regularly outperform inflation.

For example, one of the largest bond indexes in the world, the Bloomberg Barclays U.S. Aggregate Bond Index, which is a benchmark index tracking thousands of U.S. bonds, saw annual returns of 4.47 per cent from June 2005 to June 2020. Accounting for inflation over that period the average rate of return was 2.89 per cent, showing that bonds investors would have seen modest increases in the purchasing power of their money.

If we look at Australia, the Bloomberg AusBond Composite 0 Y TR AUD is the equivalent index of the US example above. Its annual return over the past 10 years has been 4.95 per cent. Accounting for inflation, the average rate of return was 3.04 per cent which again shows that Australian bondholders would have seen a modest increase in their purchasing power.

There is a caveat for both examples and that is that bond yields are tied to the overall economy and central bank policies as discussed in Part 2. Thus the current bond yields may be drastically less than historical bond yields of the pre-COVID world.

What both equities and fixed income show is that you can indeed overcome the loss of purchasing power due to inflation through investment. It also shows that blending your investments by diversifying your holdings across a range of assets not only improves your ability to beat inflation it also reduces the risks in each asset class.