How to think about inflation and protecting your capital
February 19, 2022. Stefan Willebrand.
One of the most talked about topics in the financial press right now is inflation, what does it actually mean and how do you protect yourself from it and profit?
Well, inflation means that costs of goods and services are going up, it becomes more expensive to live and to cope with it you have to make sure that your assets are appreciating and that you are paid more for your work.
Inflation is the reason that your hard-earned cash should never sit in a non-interest generating account with a bank. Why would you lend your money to the bank and just let them have it for free?
You could lose half your buying power over 10 years
If the inflation rate is 4 %, as it is in many regions right now, it means that the buying power of cash will decrease by 4 % per year. If you have EUR 10,000 sitting in a non-interest generating bank account, it means that the value of the cash has decreased by 33 % over a period of 10 years. If you were saving those 10K for making a 10-year anniversary trip with your spouse or for making an investment in your company like building out your storefront. This means that the price of the trip or the price of building out your store has increased. What you could have bought for EUR 10,000 about 10 years ago now requires you to pay about EUR 15,000 for. That is 50 % more than you needed 10 years ago, and you were thinking that you protected your cash by keeping it in a “safe” bank account! I can guarantee you that your bank made more than those 50 % from your money during that time.
Is 4 % inflation normal?
No, it is not, at least not historically…but 2 % inflation is. If I adjust the calculation to 2 % per year this still means a price increase over 10 years totalling 21.9 %.
Do you still think keeping your cash in a non-interest generating bank is safe?
What is the solution then?
Well, having assets always means that you have a risk. With cash the most obvious risks are inflation, the value of your currency dropping in relation to other currencies or your bank going bust.
For myself I like to inflation hedge through using income generating products like preference shares, gold, and commodities. Let’s have a quick look at each one.
These instruments are great if you are looking for a return between 5 – 7 % per year. The Swedish writer Marcus Hernhag (@MarcusHernhag at Twitter) has done some great writing on the topic which I highly recommend. Typically, you want to buy these instruments that are issued by companies that have a stable and profitable business. They will then pay you a fixed dividend, usually every quarter, which you can then decide to re-invest. If the shares are listed, you can buy and sell the shares in the open market and the price will fluctuate.
Since the terms for these preference shares are fixed you know how much dividend you will get beforehand.
Lets look at an example using the preference shares issued by the Swedish real estate company Corem, here is the link to Avanza with the details.
Corem pays a dividend of SEK 5 per quarter so SEK 20 per year. The most recent closing price was SEK 316 per share. If you would have bought them at this price it means that you will receive 20 / 316 ≈ 6.33 % in annual returns for the shares. If the price would drop to SEK 280 per share it would mean 20 / 280 ≈ 7.14 %. In the terms of the instrument there is also a price set where the company issuing the shares has the right to buy them back, this is important to keep track of so you don’t purchase the shares at a price that is much higher than that price which would put you at risk.
Of course, the price of the preference shares can go up and down but I am owning these for the fixed rate of return and do not care too much about the gyrations. If the yield goes up because the shares are hit by a general turndown in the stock market I might be enticed to lock that yield in and buy some more. On the other hand, if the price goes up too much I might look to sell shares and view it as if I am collecting those dividend payments early.
It is possible to invest in physical gold in multiple ways, the easiest is to buy Exchange Traded Certificates like for example Amundi Physical Gold or Xtrackers Physical Gold. One thing that is easy to miss and that usually is not highlighted in the financial press is that the price change of any asset it relative. The price of gold will show one thing if it is compared to the currency USD or the currency SEK. Living in Sweden this is where I consume and I am based in SEK so when I look at charts of gold I make sure to compare gold to SEK like you can see at the following link.
Compare that to this chart of gold against USD. Gold has been a great investment for a long time compared to SEK but not as good compared to USD. A good place to look to see how the purchasing power of various currencies compare is the Big Mac Index. This will show you how much a Big Mac costs in each country.
Another great hedge against inflation is to look at an Exchange Traded Fund like iShares Diversified Commodity Swap which has had a great run as well and appreciated more than 66 % since the beginning of 2020.
Inflation is a great threat to your wealth and financial well being and something that is worth keeping track of. There are a few good indicators that can be used to gauge how likely raising inflation is and they worked really well this time too and made it possible to go into inflation hedge investments well before inflation reached the current levels, more about that in a future article.
Non-interest generating bank accounts are a great destroyer of wealth and will drain you and/or your company of your financial buying power, it is easy though to do nothing!
Bricknode is all about building the ecosystem (the network) of financial services and providing tools for you and me to keep track of our finances and tools for the companies that provide the financial products. A lot of cool stuff is going to be launched in the network during this year, including tools that you as an investor can use to keep track of your financial health and make your life easier if you conduct investments through your own company. Stay tuned!
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