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The incredible shrinking dollar

How do we ensure that our savings are not eroded by inflation? Finance Correspondent Lorna Tan looks at how rising prices affect the value of your money and highlights the need to start financial planning early

INFLATION could hit 5 per cent in the first quarter of next year. This would be a 25-year historic high.

Trade and Industry Minister Lim Hng Kiang told Parliament on Monday that record oil prices and higher food and transportation costs could take their toll on the Consumer Price Index (CPI).

The last time inflation hit a high level was in July 1991, when it reached 4 per cent.

The CPI has been on a steady uptrend this year: It rose 0.5 per cent in the first quarter, 1 per cent in the April-June period and 2.7 per cent in the third quarter. It is expected to rise at least 2.7 per cent for the current quarter.

Inflation and value of money

SIMPLY put, inflation is the increase in prices of goods and services over time, which means it diminishes the purchasing power of today’s dollar in the future.

While $3 buys you a cup of coffee today, you might need $4 in the future. So we end up buying less in the future with the same amount of money.

There are exceptions. Prices of electronic goods such as DVD players can go down over time because of the product cycle and economies of scale.

‘With rising inflation, if you don’t look at your investments carefully and do something about it, you will find that eventually inflation will erode your purchasing power and thus your wealth,’ said Ms Anne Tay, OCBC Bank’s vice-president of group wealth management.

Mr Leong Sze Hian, the president of the Society of Financial Service Professionals, suggests using the ‘rule of 72’ to work out the number of years it will take for our purchasing power to be halved or prices to double.

This is done by taking 72 and dividing it by the inflation rate. So if annual inflation is 5 per cent, it will take 14.4 years to erode the value of today’s dollar by half.

Risk-averse investors

IT STANDS to reason then that conservative investors who put their money mainly in bank deposits will eventually end up worse off.

Investing at 2 per cent while inflation is running around 4 to 5 per cent will see your wealth steadily eroded.

Financial consultant Dennis Ng said: ‘I believe that people who play safe are actually taking very high risks. If a person puts his money mainly in bank deposits thinking he is being conservative and safe, in the long run, due to inflation, this person’s savings would actually shrink over time and he would become poorer, not richer.’

The reality is that the return from a term deposit is unlikely to keep pace with inflation and the cost of living over the long term, said Mr Gary Harvey, the chief executive of ipac Wealth Management Asia.

‘If we take a retrospective view from 1985 to 2006, a $10,000 term deposit (principal only) made in 1985 was worth only $7,500 in 2006, with an average inflation rate of 1.29 per cent per year,’ he said.

‘If inflation is 3 per cent per year moving forward, $10,000 today will be worth only $5,200 in 2028. If inflation hits 5 per cent, the same $10,000 will be worth only $3,400. Almost 70 per cent of the value will have been eroded.’

This concern is behind Ms Tay’s advice to keep only enough cash for emergency purposes, say, three to six months of your monthly expenses. Invest the rest.

Alpha Financial Advisers chief executive Arthur Lim said that when factoring the rate of return needed to meet a specific financial goal such as buying a home, retirement or children’s education, one should consider inflation.

‘An ‘inflation-proof objective’ will consider the impact of inflation and factor it into the growth needed in the investment portfolio to meet the desired goal,’ he said.

‘This will result in the investor having the precise amount needed to meet the goal, despite the price increases of assets over time.’

Starting early

HAVING a financial plan early on lets you take a long-term investment horizon, which is beneficial on various fronts.

‘The young are best-placed of course, as they stand to gain the most from compounding, dollar-cost averaging, investing at a lower risk level and maximising of returns over the long term’, said Mr Lim.

To illustrate the power of compounding, Ms Tay cites an individual who started a yearly investment of $1,000 at age 25 for 10 years, at a rate of return of 6 per cent. He allowed his investment to continue growing at 6 per cent from age 35 to 62 without any further annual inputs of $1,000. At age 62, his investment would total $71,420.

In contrast, take the case of another individual who embarked on a yearly investment of $1,000 only from age 35. He must continue the yearly input of $1,000 all the way to age 62 before the total value of his investment grows to $72,640.

That is a 28-year investment of $1,000 per annum, compared with the 10-year investment in the first example. This is simply because the first individual started 10 years earlier.

‘That’s the power of compounding, said Ms Tay.

Young working adults may not earn much but ‘they have time on their side and can always start small’, said Mr Tony Tan, a consultant with independent private wealth manager Providend. Many unit trusts allow for regular savings plan contributions from as little as $100 a month.

‘Start on a regular savings investment plan which allows you to make small monthly contributions towards the realisation of the defined objectives. What is most important though is that you start as early as possible and make time work for you,’ said Mr Tan.

Mr Leong of the Society of Financial Service Professionals says a young working adult could start with as little as $1,000, which could be invested in a global balanced fund.

He would need about $5,000 to $10,000, which could be from the Central Provident Fund (CPF) or cash, to set up a globally diversified portfolio of about a dozen funds.

‘Assume a 25-year-old is earning $1,450 a month, with $60,000 in CPF. If he can get an average return of 5 per cent on his CPF accounts, his investments can grow to over $900,000 by the time he reaches 65. At 6 per cent, it can grow to over $1.2 million,’ said Mr Leong.

To take care of rainy days, keep six months of expenses as emergency cash in a money market fund or a fixed deposit, one-month renewal account at a bank.

Older investors

IF YOU have a shorter time horizon, common sense dictates that you shouldn’t be investing mainly in risky instruments.

However, with the longer lifespans these days, investing your entire nest egg in something too conservative may not give you the returns required to fund your retirement needs, said Mr Tan.

A balanced globally diversified portfolio would typically comprise about a dozen investment funds made up of approximately 55 per cent equities, 5 per cent commodities and 40 per cent bonds, said Mr Leong.

If and when you need money, he suggests liquidating the funds that have gone up the most so you will always be exiting the funds with gains.

On a positive note

THE good news is that inflation is generally not a ‘bad’ thing, as it is typically accompanied by a robust economy, which in turn results in higher incomes.

The increase in wages should be more than enough to offset the increase in the prices of goods, said Mr Tan.

For instance, inflation in Singapore should be viewed against rapid economic growth, with gross domestic product rising more than 6 per cent on average since 2003 and wages also on the increase.

Moreover, inflation is expected to moderate in the second half of next year.

The spike in inflation to 5 per cent in the first quarter of next year is likely to be followed by a plateau, as the rate reverts to more normal conditions in the second half.

For the whole of next year, the average inflation rate is likely to be around 3 per cent.

 

Source: The Sunday Times 18 Nov 07

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