The average cost of a bottle of Coca Cola in 2005 was ₦35. By 2018, it was ₦100. That's the effect of inflation in action. The Nigerian’s Consumer Prices Index (CPI) measure of inflation, which tracks how the prices of hundreds of household items change over time, jumped to 11.28% in November 2018, up from 8.0% in December 2014.
Over the years Nigerians are experiencing higher airfares, food costs and petrol prices fuelled by the weak naira all helping to drive up the cost of living. This rise occurs sometimes quickly as witnessed in Nigeria between 2015 to 2017 and at other times slowly. That fact has great relevance to your personal savings plan.
What causes inflation?
There are several different factors that may create inflationary pressure in an economy. Rising commodity prices can have a major impact, particularly higher oil prices, as this translates into steeper petrol costs for consumers.
Stronger economic growth pushes up inflation too, as increasing demand for goods and services places pressure on supplies, which may, in turn, lead to companies raising their prices.
The falling naira is also contributing to higher inflation in Nigeria, as it makes the cost of importing goods from overseas more expensive.
How Inflation Shrinks Savings And Investments
Inflation is bad news for savers, as it erodes the purchasing power of your money. Low-interest rates also don’t help, as this makes it even harder to find returns that can keep pace with rising living costs.
effect of Inflation On Your Savings
Let’s say you have ₦100,000 in a savings account that pays a 3% interest rate and with inflation at 5%. After a year, you will have ₦103,000 in your account. But, to have the same buying power that you started with, you would need ₦105,000.
Its simple to assume that you've gained three thousand nairas but you lost buying power. Any time your savings don’t grow at or above the rate of inflation you will effectively lose money.
If you are a retiree living on your savings, you can’t keep up the same standard of living if inflation cuts into your purchasing power with every passing year. This is especially true in Nigeria where medical costs tend to rise at a greater rate than many other costs.
Inflation can hurt well before retirement. If you are steadily saving money with a goal in mind, such as a college fund for your children or a down payment on a home, the purchasing power of your money may decline while you're saving it.
effect of Inflation On Your Investments
Higher inflation can also drive down the price of bonds. These become less attractive because you’re locked in at interest rates that may not keep up with the cost of living in years to come.
One option is index-linked gilts, which are government bonds whose interest payments and value at redemption are adjusted for inflation. However, if they’re sold before their maturity date, their market value can fall as well as rise and so may be more or less than the redemption value paid at the end of their terms.
Investing in equities can potentially provide better protection against inflation than deposit accounts or bonds, which aren’t index-linked because companies can raise prices to cover higher costs. That, in theory, should enable them to grow at the same rate of inflation over time.
However, it is important to note that investing in equities carries a high risk of losses and you must be prepared to accept that you could get back less than you put in and that the value of your investment may not keep up with inflation.
How do you measure the effect of inflation on your savings? The government measures it for you and publishes the results regularly.
The Consumer Price Index (CPI) tracks the prices of a variety of consumer goods and services, including transportation, medical care, and housing. The index is published monthly.
How to Safeguard Your Savings
The primary way to beat the effect of inflation is to invest your savings for a better return than you can get in money market accounts or savings accounts.
Investing in virtually anything else inevitably involves greater risk that an FDIC-insured account. But you can choose investments that have a level of risk that you can tolerate.
Returns on stock investments generally tend to beat inflation. Investors who want to avoid the volatility associated with individual stocks might opt for mutual funds, which are professionally managed and aim to provide a good return over time.
A mutual fund that follows a passive indexing approach might be even better since it is not dependent on the stock-picking abilities of any particular fund manager. The stock market overall tends to go up over time. You will also pay less in fees with an indexing approach.
Where To Invest Your Money
Companies that raise their prices in line with inflation tend to fare better than others when the cost of living is increasing. Energy companies, for example, may perform well in an inflationary environment as they can raise their prices in line with inflation. Infrastructure companies such as those responsible for toll roads, government buildings, and hospitals, may also do well, as they often have long-term government contracts in place with payments linked to inflation, which encourages private-sector investment.
Other companies that tend to be resilient to inflation are those producing consumer staples, which will always be required, regardless of what happens to prices. These include companies that produce food and drinks or other essential items such as cleaning products, toothpaste, and prescription drugs.
Please bear in mind that our mentioning these kinds of companies doesn’t constitute a recommendation and if you’re unsure about investing you should seek professional financial advice.
Remember that investments can fall as well as rise and you may get back less than you invested. Past performance isn’t a reliable indicator of future performance.
Wrap It Up!
One major effect of inflation is that it tends to cut into a consumer’s purchasing power over time. Fortunately, there are ways of you can preserve the purchasing power of your savings. That means investing, but keeping your level of risk moderate.
The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.