You hear the word inflation everywhere in the news: “The inflation rate reaches record highs!”. But what is inflation? In this article, we will discuss what inflation is and the steps you can take to protect yourself and secure your financial future.
What is inflation?
When you hear your grandparents say: “Oh, everything was just so much cheaper when we were young, ” that’s a great example of inflation. Inflation is the devaluation of money – or rather the decrease in purchasing power. Whereas before you could buy bread for 1 Euro, it now costs 2 Euros due to price appreciation.
Essentially, this shows that you get less value for your money in periods of high inflation. Inflation happens for many reasons; for example, an increase in the availability of funds due to more money being printed or a shortage of goods because of supply chain issues. In terms of the latter, this leads to a shift in the ratio of available goods to available money.
Inflation is a regular occurrence in the economic systems of developed economies, with around 2-3% per year being seen as healthy since it can help stimulate economic growth. However, the inflation rate can also go much higher. This is evidenced why European economies right now, where annual inflation is expected to reach 7.5% in March 2022.
The thing with inflation is that it’s invisible. No one will take the money out of your wallet, cross out the 20 and make it 10! The bill and denomination of your money stay the same – it just has less purchasing power. That’s why many people aren’t even aware that inflation is such a huge concern.
How is inflation calculated?
You can see that inflation is often discussed in annual percentages. To calculate the increase in the average price level, one takes a basket of selected goods in proportions that make up an average household and determines each item’s price increase.
For example, this basket may contain:
- Your rent
- Food (divided up into vegetables, meat, oil, milk etc.)
- Gas prices
- Clothing items
The European Central Bank has this visual representation of the inflation rate and which factors contribute to it. As the inflation rate is calculated by using a basket of goods, the inflation rate for individual people could be much higher or lower than the official rate.
Do you drive your car a lot or have a business that consumes a lot of gas? Then you’ll likely see a higher impact than someone who rides their bike everywhere. So it’s essential to keep that in mind when thinking about inflation, as ultimately, it ends up being a personal matter.
Investing is how to protect against inflation
When your money steadily decreases in value, you need to protect yourself. A common solution is to invest your money in a way where you make returns at least of the same magnitude as the inflation rate.
Let’s take Germany as an example of how it used to be and how that might change. If we compare the historical interest rates and inflation rate for Germany in the last 20-40 years, we can see that prevailing interest rates often roughly match the inflation rate. So if all you did was leave your money in the bank account, it would slowly grow by a couple of percentage points every year – just enough to combat inflation.
However, in current times, banks often provide 0% interest. This, coupled with an inflation rate of 3-7% annually, leads to a continuous reduction in spending power. To combat this, it’s imperative to invest your money – and invest it so that you’ll get higher returns than the inflation rate.
Asset classes that offer returns to combat inflation
Now we will discuss three asset classes that can provide you with returns higher than the inflation rate – so you not only end with a zero at the end of the day but a plus!
The P2P in P2P Lending stands for “peer-to-peer”, meaning that lenders and borrowers directly interact without an intermediary. This concept benefits both parties, such as effective capital investment for the lender and quick and easy funding for the borrower.
P2P Lending platforms often provide interest rates north of 7% – in many cases even going up to 15%. In addition, sometimes they offer a so-called ‘buyback guarantee’, which acts as protection against the borrower’s default risk. Usually, this involves loans with outstanding payments being repurchased so that you are not left out of pocket. In some cases, this even involves paying out the interest you would have accrued.
Another asset class that has historically outperformed the inflation rate is stocks. For this, we can compare the performance of a market index such as the S&P 500 to the corresponding inflation levels. If we look at this index’s historical performance, it has returned just over 10% annually, although this is not adjusted for inflation.
But even after being adjusted for inflation, the annual rate of return is still 7%. This makes it a reliable asset class to beat inflation – and even make gains.
If you are a real estate investor, then inflation can actually be helpful to you. This is because of the way fixed interest rate loans work. Let’s say you take on a loan for 200,000 Euro at 1.0% and fix it for 30 years. Then you will only pay 1% interest in perpetuity.
So, in 20 years, you will still be paying back the loan with 1% interest, while your money could have lost 2% in value every year due to inflation. This means you are essentially paying back the loan with cash worth less than what you originally borrowed!
While inflation cannot be seen, it should be viewed as a threat to your wealth and must be addressed. Leaving your money in the bank at 0% interest, or even keeping most of it at home, will only lead to it decreasing in value if you do not make any moves to stop it.
The best approach to combat inflation is by investing. Pick an asset class that you feel comfortable with and that offers interest rates equal to or higher than the inflation rate, and the result will be a steady increase in your portfolio’s value.