As time goes by, the value of money changes depending on the rate of inflation that is in place at that time. Inflation has the potential to destroy real return as it can eat up the true value of your money. In order to get a real return on your investment you must always deduct the impact that inflation has on the investment.
Example: If your investment has earned 10% for a single year, the real return is actually 10% less the inflation rate. Depending on the rate of inflation, that real return could be lower than the inflation rate and as such that means that on paper your money has gained in value but in reality it has actually lost value.
The Rule of 72
A simple rule that can be used to determine the value of your money is the rule of 72. This rule serves as a guide to determine how long it will take for the purchasing power of your money to reduce by 50% given a specific rate of inflation.
It is a simple formula:
72 / (Present inflation rate) = number of years it will take to reduce the purchasing power of your money by 50%
Example: If we use the current CPI (consumer price inflation) figure as published by the South African Reserve Bank of 4.1% and we apply the above formula:
72 / 4.1 = 17.5 years
This means that it will take 17.5 years for the value of money to reduce by 50% if the inflation rate is 4.1%. This will always be a moving target due to the fact that the inflation rate changes frequently.
The important message to take away here is to always monitor your investments to understand the real return that it is or is not producing. Then consider diversification in the way your investment is constructed. This allows your money to get exposed to some growth to ensure higher than inflation returns on investment, which will then lead to a positive real return.
On a yearly basis, consider the rule of 72 and see whether the value of your investment in relation to inflation is actually gaining value or losing value. Depending on what the outcome is, it will help you to understand what needs to be done for the following year. It can be a great and simple investment tool.
Please consult a financial adviser/ investment adviser whenever you enter into any investment products.
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