What is Inflation?

Inflation is defined as a sustained increase n the general level of prices for products and services, which is measured as annual percentage increase. As inflation rises, every ringgit you own buys a smaller percentage of a product or service. In other words, there is a decline in your purchasing )power. For example, theoretically a RM1 cup of teh tarik will cost RM1.05 after a year if inflation rate for the period is 5 percent.

What is Consumer Price Index (CPI)?

The Consumer Price Index (CPI) measures the percentage change in the cost of purchasing a constant "basket" of goods and services by a particular group of consumers (60% urban, 40% rural) over a specified time.1 The items in the "basket" can be grouped into the following:

Food and non-alcoholic beverages

Alcoholic beverages and tobacco

Clothing and footwear

Housing, water, electricity, gas and other fuels

Furnishings, household equipment and routine household maintenance

Health

Transport

Communication

Recreation services and culture

Education

Restaurants and hotels

Miscellaneous goods and services

However, you should note that the CPI is a statistical average and may not reflect your own inflation rate. especially if your spending patterns differ substantially from the standard urban consumer. Most of the time, inflation rate at the personal or consumer level for city folks could be twice or higher than that of the national level.  

What Causes Inflation?

The two generally accepted causes of inflation are:

1. High demand, low supply - If demand is growing faster than the supply of products and services, prices are forced upwards. Also known as demand-pull inflation, this normally occurs in growing economies when there is "too much money chasing too few goods".

2. Rise in production costs - When the price of raw material goes up, production cost will rise, which leads to companies increasing prices to maintain their profit margins. This also applies when employees demand higher wages as companies usually pass on these costs to the consumers.

What are the Effects of Inflation?

Although inflation can be considered a normal economic development as long as the annual percentage remains low, it can cause a crisis once the percentage rises over a pre-determined level. The most obvious way it can affect your personal finance is by significantly reducing your purchasing power. You will find that the price of everyday products and services rising and with interest rates going up as well, loans will often cost more.

For Example:

?In 1978 (30 years ago), RM300 can buy one month's worth of groceries for a family of four.

?In 2008, RM300 can buy one week's worth of groceries for a family of four.

? In 2028 (20 years later), RM300 can probably buy two day's worth of groceries for a family of four.  

By understanding the difference between nominal returns and real returns, you will be able to see the impact inflation will have on your funds. Nominal return refers to the growth rate of your money while real return is the growth of your purchasing power, which is the nominal return reduced by the inflation rate. Hence, monies that are placed in fixed deposits may lose their value over time due to the eroding effects of inflation.

For example: 12-month fixed deposit rate = 4% Inflation rate (personal level) = 6% _ Real return on investments = 4% - 6% = -2%

How can we Beat Inflation?

After discovering how inflation can drastically reduce your spending power, investors should consider building some protection in their portfolio against its eroding effects. Here are some ideas on how you can mitigate the effects of inflation:

1. Get higher return and yield from your investments. When it comes to protecting your savings from inflation over the long term, the best option is to get returns from your investments which are higher than the inflation rate. Equities and equity funds as well as stocks that pay high dividends should be considered as they can mitigate the effects of inflation.

2. Maintain diversification in your portfolio.

A balanced portfolio of stocks, bonds and money market securities can help reduce risk and provide a hedge against inflation, because an investment type may be in favor when another isn't doing as well. However, diversification does not protect against loss in a declining market.

3. Minimize holding large amounts of cash.

Although holding cash or placing them in fixed deposits offers liquidity, the funds may lose their value over time due to inflation. Instead, low-risk investors might want to consider shifting their funds to a balanced portfolio (comprising 60 percent equities and 40 percent bond) to provide good inflation-adjusted returns over the medium to long term period.

4. Invest in resilient sectors. During volatile market conditions, investors can gain exposure to defensive sectors and blue-chip stocks i.e. telecommunications, utilities, transportation sectors, etc to hedge against inflation. Gold is also perceived as a safe haven in financial instability or rising inflation.

5. Manage debt. It makes sense to keep debt to a minimum because interest rates rise in tandem with inflation. It is always wise to dear off your highest-rate loans as quickly as possible, but it is especially important when interest rates are rising.