How Much Should Your Investments Grow to Beat Inflation

How much should our investments grow each year?

 

Most of us would answer that our investments should, at the very least, beat inflation. 

 

Despite the simplicity of this guideline, many investors do not really understand what it means. Or if we understand what it means, we do not know how to apply it to our investment strategy. 

 

For many of us, as long as our investments have positive returns, we’re good. Never mind if the said returns are barely able to cover inflation. 

 

In this post, I will reinforce why we should target to beat inflation AND figure out what inflation figure should we use for planning purposes. 

 

But before we start, what does beating the inflation mean in practical terms? To answer this, we have to know: 

 

  • What inflation is, and
  • What is the inflation rate we need to beat
 

1. What is inflation?

Inflation, according to Investopedia is:

 

... a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over a period of time. It is the constant rise in the general level of prices where a unit of currency buys less than it did in prior periods. Often expressed as a percentage, inflation indicates a decrease in the purchasing power of a nation’s currency.

Investopedia

In simpler terms, it’s the increase in the price of goods and services in time. A.k.a., how much your money now can buy in goods and services in the future.

 

For instance, in 1980, the basket of goods and services you want to buy cost Php 100. This is how it will cost in the following years:

  • 10 years later in 1990, the same basket of goods and services costs Php 403.75.
  • In 2000, the same basket of goods and services that used to cost Php 100 in 1980 can now be had for Php 969.57. 
  • In 2010, you need Php 1526.21 to buy the same stuff
  • In 2018, it’ll cost you Php 1904.08 to buy things that people in 1980 used to buy for Php 100.
 

 

inflation from 1980 to 2018

To make your own comparisons, you can use this handy online inflation calculator.

So why the need to keep up with inflation? 

 

Because if your investments do not keep up with inflation, it’s actually losing value because you will not be able to buy the same basket of goods and services for the same amount of money. 

 

Your Php 100 will not be able to buy the same amount of goods and services in 10, 20, and 30 years. Your money buys less now than it did 10, 20, or 30 years before.

Can't we just be happy with any positive growth rate?

The purpose of investing is to grow your money. Growing your money means not only increasing its absolute value, but also increasing its value vis-a-vis inflation, that is, how much that money will be able to buy, year after year. 


Say your money grew by 5% in absolute terms but inflation for that same year is at 5.21% (the Philippines’ inflation rate in 2018), that means that despite your investments growing by 5%, it actually lost value because it was not enough to cover the increase in the price of goods of services for that same year.


Again, you are losing the value of your money if you don’t take inflation into account. 


Now that we understand why we need to at the very least, beat the inflation rate so that our money will not lose value, we need to figure out which inflation rate data we will use for planning our target annual returns.  

2. Which inflation data should we use?

Although many institutions and banks issue their inflation projections, I think we basically have two options for inflation rate data to consider: 


  • the historical inflation rate calculated by the Philippine Statistics Agency (PSA) and 
  • the inflation rate projection by the Bangko Sentral ng Pilipinas (BSP)
 

It is the PSA that calculates and announces the previous year’s (and month’s and quarter’s) inflation rate while the BSP makes predictions (that is, very educated guess) of what it thinks will be the inflation rate in the future based on indicators. 

Inflation Projections by the BSP

We might be tempted to use the BSP’s projected inflation figures to plan our investments. For example, you may:

 

  • Aim to gain 3% in investment returns in 2020 to match the 2020 BSP inflation projection
  • Plan to gain at least 2.9% for 2021 to match the 2021 BSP inflation projection

(Figures from this PNA article.)

 

But I don’t think it’s a very good idea to use projected numbers. Why? 

 

For the simple reason that inflation is hard to predict, even for the BSP. The BSP regularly adjusts and readjusts its forecasts. And even after readjusting their forecasts a number of times, the final inflation rate would still be different from any of the numbers they previously gave.

 

Don’t believe me? Here is an example of the BSP’s projections in the past couple of years: 

As such, the BSP also raised its inflation forecasts for 2017 and 2018 to 3.5 percent and 3.1 percent from 3.3 percent and 3 percent, respectively, Deputy Governor Diwa C. Guinigundo said. Guinigundo attributed the higher forecasts to increasing fuel prices and the depreciation of the peso since the fourth quarter of 2016.

Philippine Daily Inquirer, Feb. 10, 2017

According to this news report, the BSP’s original inflation rate forecast for 2017 was 3.3%, eventually adjusted to 3.5%. The final inflation rate announced by the PSA? 2.85%. 


Good right? The final figure was actually lower than the BSP’s projections. 


But then consider that the BSP’s original inflation rate projection for 2018 was 3%, eventually adjusted to 3.1%. The final inflation rate announced by the PSA for 2018? 5.21%. 


So, it could go either way. The final figure can be either lower or higher than the BSP’s projections.

 

In case you’re thinking that this is peculiar only to the present Duterte administration, look at these news report from October 2010 and January 2011: 

The central bank forecast average inflation this year to reach 4% before slowing to 3.25% in 2011. It expects inflation in 2012 to settle at 2.97%.

ABS-CBN News, Oct. 10, 2010

The BSP has raised its forecasts for inflation for 2011 and 2012 to 3.6% and 3%, respectively. Both are below the midpoint of the government's 3% to 5% target range.

ABS-CBN News, Jan. 5, 2011

The BSP’s forecast for 2011 was 3.25%, eventually adjusted to 3.6%. The final figure was 4.7%.

 

In 2012, the projected inflation was 2.97%, eventually adjusted to  3%. The final figure was 3.2%.

 

My point is,  basing your investing plans on the inflation rate projections by the BSP is not a great idea because:

 

  • The BSP regularly adjusts its projections, and
  • The updated projections may still be higher or lower than the final inflation rate, but we can’t tell in advance for how much 
 
It wouldn’t even help if you regularly adjust your investment allocation and strategy based on the adjustments made by the BSP. In the end, it can still be all wrong. 
 
 

It doesn’t mean that the BSP is bad at its job. It’s just that a lot of factors affect inflation, many of which are beyond our government’s control. There are too many factors, too many unknowns in the equation. 

 

Additionally, and I think this is very important, if you’re like me who wants to keep your investments simple and stress-free as much as possible, I don’t want to be making adjustments in my investment portfolio every time the BSP adjusts its inflation rate projections. I want to do one thing and then just revisit doing that thing once a year, twice at most.

 

Historical inflation rate data

Another option is to use the average historical inflation rate. 


I want to make it clear before continuing that yes, using historical data reveals a hindsight bias. 


Also, just because something didn’t happen in the past, it’s not going to happen in the future. Conversely, just because it happened in the past, it will happen again in the future.


But, we have no way of predicting what’s going to happen in the future. 


So, I think that if we’re going to make plans for anything, using exhaustive historical data is a good start. 


Also, the more data points we incorporate, the better we can account for randomness and volatility of the factors that affect inflation. 

Annual Inflation rate 1958 - 2017
Inflation rate from 1958 to 2017

So this is how the Philippines’ inflation rate (adjusted to base year 2012) from 1958 to 2017 looks like.  Based on this (and adding the 2018 data) we can calculate the average annual inflation rate from 1958 to 2018 to be a whopping 8.36%.

 

So if we’re going to base on historical inflation information, our investments should grow on average, at least 8.36%.

 

Why at least? Because a growth rate of 8.36% will just keep your money at par with inflation. And since we want to gain mooooore than inflation, we should plan to beat 8.36% annual average growth rate.

 

So let’s say that you were a 20 year-old whippersnapper in 1958 and you wanted to make sure that when you retire in 2018 (you have a very long life), your money will grow at least at the same rate as inflation. 

 

So what should you have done? You should’ve invested your money in financial instruments and other assets that would’ve given you an average annual growth rate of at least 8.36%. 

What if remove inflation data from turbulent years (and other outliers)?

I know many of you will think that the 8.36% average annual target growth rate is too high. I agree. But that doesn’t change the fact that that’s how inflation has behaved in the Philippines in the past. I didn’t make up the data. That’s just how it is. We need to suck it up. 

 

You may be thinking: but Katie Scarlett, can’t we just remove those years when the Philippines’ inflation rate were highest because of some event, like during the People Power revolutions?

 

Some people tell me that I shouldn’t include the data for the years when the first and second People Power Revolutions happened (1986 and 2001, respectively), sure that inflation rates were abnormally high for these years.

 

But were they? 

 

Actually…no. In 1986, the inflation rate was a very low (for the Philippines) 1.1%. In 2001, the inflation rate was 5.4%, which was not very high either. 

 

There are also other people who think that we should just remove the highest inflation rate because it skews the data (an argument that I don’t agree with). But even removing the data for 1984 when the Philippines reached an eye-popping 49.8% inflation, we would still have an average annual inflation rate of 7.67%. 

 

Well, so long as we’re cherry-picking, might as well remove the second-highest inflation rate too, which was in 1974 at 31.8%. Even after removing the 2 highest inflation rates in the past 61 years, the average annual inflation rate is still at 7.26%. 

 

We can cherry-pick at the information all we want but I’d advise against it. Let’s just embrace the fact that the Philippines has really unpredictable inflation, historically. Instead of ignoring the historical data, why don’t we just plan based on what the data says, especially if you’re investing for the long-term.

 

Others might say that the government has finally figured out inflation, and that the Philippines will no longer experience unpredictable inflation rate like we did in the past. They will tell me in that:

 

  • Starting 2010 until 2018, the average inflation rate is  3.11%
  • From 2000 to 2018, the average inflation rate is 4.063
 
 

They are of course correct. Starting 2010, the country’s inflation rate have been low (compared to the past, not compared to other countries). But not only are these data snapshots of the wider picture, it totally ignores the fact that there inflation is affected by so many factors outside of our government’s control.

 

I don’t think it’s paranoia to consider the fact that the Philippines does not have the sturdiest of democracies and the strongest fundamentals. Its bureaucracies are not efficient, its institutions opaque, and giant corporation are brought down by the whims of those in power. 

 

Add to the mix how sensitive we are to price changes of commodities that we don’t produce, like oil, and sadly now, rice. 

Final thoughts

For long-term investors such as myself and those who are preparing for long-term goals like retirement in 30 plus years, we need to carefully plan how we should set our investments so that it will “beat the inflation”.

 

Based on historical PSA data since 1958 to 2018 (2019 inflation data is not yet available at the time of writing), the average inflation rate in the Philippines is 8.36% 

 

For us to beat the inflation, our investments should grow an average of at least 8.36% annually to account for inflation

 

Do you consider inflation when you invest? If so, how do you incorporate it to your investing? I’d like to hear your thoughts on this matter. 

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2 Responses

  1. hi KS, I also believe that we should include the ‘bad’ years when computing for the historical average of inflation rate. in a way, this gives room for considering future market crashes (another revolution, maybe?).

    1. Thank you for agreeing with me, Mark. You’d be surprised to know that several people have told me that “bad times” are never going to happen again and/or the economy is now so stable that we will no longer experience runaway inflation ever.

      KS

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