Risk is an unavoidable part of life. What comes to mind when you think about financial risk? Investing in the stock market? Overpaying for something? Losing your job? Being broke at retirement?
In this post series I’ll discuss the ways you may be risking your money. Being aware of these will help you make smarter choices when managing your money.
Part One – Inflation Risk (or the risk of running out of money)
When I first started working, almost twenty years ago, you could rent a one-bedroom apartment for around $400 a month. Now that cost has roughly doubled, with apartments easily going for $800 a month.
This is the risk of inflation. It’s a gradual change so we don’t really notice these small increases in our daily spending. But when you compare prices going back a decade or more, the price jump is obvious.
How much is inflation?
There’s significant variation in the inflation rate depending on where you live and what products or services you are purchasing. But there are ways to get a rough idea of what the inflation rate has been previously, and what it may continue to be.
If I take my first example of prices doubling in 20 years, that’s an inflation rate of 3.5%.
If you look at the Consumer Price Index (one measure of inflation) from the last 20 years the average is 1.85%. That’s not too bad. However if you look further back the period from the early 1970s to the early 1980s inflation was around 10%. Yikes!
We can’t predict exactly what inflation will be in the future, but over a long enough time frame it will significantly affect your spending requirements.
How will this actually affect me?
Let’s take my original example of rent increases every 20 years. At a (possibly) conservative 3% inflation rate here is a table showing what we may expect to pay for rent* in the future.
Example Rent Costs Over Time
Year My Age Rent Cost
1997 20 $400
2017 40 $720
2037 60 $1,300
2057 80 $2,300
2077 100 $4,200
It doesn’t seem too bad for the first few decades, but I can already see that this example of 3% doesn’t reflect the reality of housing prices, at least in Winnipeg. The cost of housing has probably been rising faster than 3% per year, as it’s only 2015 now and there aren’t many one-bedroom apartments available for $720. The $800-900 range is more common. And what if you live to be 80 or older? And don’t qualify for subsidized housing options?
The above is just an illustration. It may or may not apply to your actual situation. But the point of the example is to show how costs change over time. Losing purchasing power is a very real risk.
Inflation and investing choices
This is the risk that people take when they only invest in so-called “safe” investments – products like GICs and savings accounts where the principal is guaranteed. If you are worried about losing money in the stock market, not investing in the stock market isn’t any safer. Sure, you have your original $100,000 but that’s not going to go very far when prices have doubled or tripled.
One important way to analyze your investments performance is to calculate the Real Rate of Return**. This is done by taking the Nominal Rate of Return (the rate the bank gives you) and subtracting the Inflation Rate.
For example, if you have a GIC earning 2.5% per year, and inflation is 2%, you are actually only earning a measly 0.5%. Even worse is if you have a GIC or a savings account that is earning 0.9% or worse. You may be making a negative real return. Think about it – the bank is using your money to make more money for its shareholders and you are paying them for the privilege. They should be paying you to borrow your money.
The horrifying conclusion
Remember if inflation is higher than your investment return you are losing money, as surely as if you were burning it.
What can I do to reduce the risk?
My recommendation is a method of stock market investing known as Passive Investing or Index Investing. If you follow a few simple rules you can keep your money reasonably secure and get a higher return on your investments, greatly reducing your inflation risk.
I’ll discuss the details and rules of index investing in a future post. But in the meantime I highly recommend you check out the website Canadian Couch Potato. I have no affiliation with this site. I just consider it to be the absolute best place for Canadians to learn about index investing.
One tip though when browsing: If you are a novice investor just start with reading the three top tabs of “FAQ”, “Recommended Funds” and “Model Portfolios”. The site owner’s high level of expertise can make some of the posts too confusing if you’re just getting started with investing this way.
In future posts I’ll discuss other ways your money is at risk.
* This is one reason people consider owning a home to be a hedge (risk reduction method) against inflation. But that’s only one factor to consider, and many homeowners may return to renting later in life.
** Real rate of return should be adjusted for taxes as well, but I know you’re using your TFSA so aren’t paying taxes.