The South African Reserve bank has just announced an interest rate cut from 4.25% to 3.75% confirming that the country is in a falling interest rate cycle. This decision is a third major cut and we are not even in the middle of the year. With interest rates currently at record lows, savers will find that the interest earned on bank deposits or money market accounts is lower than the prevailing inflation rate.
Understand the impact of inflation
Investors often look at returns without taking the impact of inflation into account. When assessing the success of an investment, we calculate the real return of that investment. The real return is simply the return an investor receives after the rate of inflation is taken into account. The math is straightforward: if a bank deposits returns 4% in a given year and the current rate of inflation is 4.6%, then the real return is negative 0.6%. This of course means that the purchasing power of the money invested in this bank deposit is being slowly destroyed.
Think of it this way: Assume that this year, it takes R1, 000 to feed your family for a month. If inflation is running at 4.6%, then next year that same shopping basket of food will cost R1, 046 when you add inflation. If the return on your R1, 000 investments is just 4%, then you will have only R1, 040 at the end of the year. However, your purchasing power has been diminished by the difference between your 4% nominal return and the 4.6% inflation rate. This means that your real return is a negative 0.6% or a loss of R6 for every R1, 000 invested. In order to properly manage your investments, your return earned on bank deposits or money market accounts must be higher than inflation.
Low interest rates affect investor decisions
Most investors who save using bank deposits or money market accounts do so because they seek regular income and capital protection. As a result they consider an investment a success as long as they can consume income without ‘touching’ the amount of money initially invested. Those investors who stick to the traditional banking investment options will now be forced into gradually lowering their standard of living in an effort to make ends meet from their income. Secondly, those who wish to maintain their standard of living while not spending their capital must take some risk in an effort to do so. Or if you have expenditure needs greater than the income payments provided by your bank deposits or money market accounts, you will be forced to start consuming the amount of money initially invested.
Bank deposits or money market are only suitable for short-term savings
There is still limited knowledge of the available investment options the public can use to improve their financial well-being. A large portion of savings in black communities are still held in call and fixed deposits. These products are commonly used by individuals as a safe haven solution. They are only suitable for short-term savers or retirees, who don’t want to accept any losses on their investments. We are aware that you need a savings discipline to become a better investor, but the difference between saving and investing needs to be clearly defined. Acting like a saver when you should be acting like an investor, or vice versa, can have negative long-term penalties on your financial security.
Strategies that achieve long-term returns that are superior to bank deposits
The world is filled with options on where you can invest your money. Owning a portfolio that consist of investments in a variety of asset classes (shares, bonds, property, commodities and money market) can help reduce the risk in your portfolio while producing long-term returns that are superior to bank deposits or money market accounts. We have seen that choosing an appropriate asset class is difficult for an individual investor. Investing, especially without the help of a financial adviser nowadays is not recommended, unless you have the skill and knowledge to do it yourself. In fact, buying a financial product is probably one of the most complex, challenging things we do, given the growing diversity of products and the greater amounts of information investors are expected to know.
Be aware of the impact inflation is having on your investment returns
The real return (after subtracting inflation) of an investment isn’t the only consideration or, sometimes, even the primary consideration. Investors also need to focus on other considerations, including their long-term goals, the duration of their investment horizon, and their risk tolerance. In all cases, it’s important to be aware of the impact inflation is having on your investment returns. When evaluating an investment, be sure to consider its real return, rather than simply looking at its nominal return. Keeping this in mind will help you manage the purchasing power of your savings.