Hedging against Inflation

Inflation is an increase in the general price of basic things over a a period of time.   Essentially inflation 'reduces' into the value of your money. This is best explained by a mathematical formula know as  "Rule of 72" which will indicate how much the value of your dollar will depreciate/or cost will raise with inflation.  Eg:  If inflation raises by 6% per year, costs will double in 72/6 or about 12 years.  What cost RM1.00 today will cost RM 2.00.in 12 years time.  The purchasing power of RM100,000 would fall to just RM17,000  Thus keep inflation from wiping out your nest egg by:

1. Save more by reducing your unwanted expenses.
2. Invest the money wisely rather then just letting it stay in the savings account for a lesser than inflation rate return.
3. Purchase a property as it will increase in value to keep pace with inflation.
4. Invest in a business which will increase income and capital value over time.
5. Invest in equity or balance unit trust funds that give a return higher than the inflation rate.
6. Consider gold and other metal and commodities.

Fixed Deposit

Keeping one's savings in fixed term deposit may probably be the safest on an investment risk-return continuum, but it, nevertheless, carries with it the risk of negative return when the rate of inflation is higher than the rate of interest received from the fixed deposit, leading to a loss in purchasing power per dollar principal to the saver: otherwise know as the inflation or purhasing power risk.  Direct investments in the share market will subject the investor to the specific risk of falling share prices without reprieve offered by the benefit of portfolio diversification or fund management expertise available under collective unit trust investment schemes.  

How do You do Asset Allocation

Studies have shown that somewhere between 77% and 94% of the variability in portfolio returns are determined by asset allocation. So our goal is to use asset classes with low correlation to get the best reward/risk ratio. One of the most popular examples of assets that have low correlation is stocks and bonds. Accordingly, adjusting your ratio between stocks and bonds is one of the most basic ways to adjust the amount of risk you wish to take in a portfolio. The chart below shows the risk/return trade-off between bonds and stocks for 1980-2004. The stock portfolio is represented by the S&P 500 index, while the bond portfolio contains 60% five-year Treasury notes and 40% long-term Treasury bonds. The portfolios range from 100% bonds, to 95% bonds/5% stocks, 90% bonds/10% stocks, all the way to 100% stocks.

It’s interesting to note that being 40% stocks/60% bonds actually ends up with the same level of risk, but almost 2% more in average annual return. I think this is a big part of why you won’t see many model portfolios with more than 60% bonds. Also, I would note that as you get near 100% stocks, the slope of the curve gets flatter and you start taking on more risk without getting as much higher return.

How Much Risk Should You Take?

Now, actually deciding on how much risk you need to take is very difficult. You need to be able to keep your asset allocation in both good years and bad years, so in on one side you have to measure how much risk you can take – risk tolerance. On the other side, there is a certain amount of risk you need to take in order to outrun inflation and reach your investment goals. Finally, you have to take into account that risk also decreases over time. 

You can see here why stocks are considered a good long-term investment, but a horrible short-term investment. This chart shows that for any 25-year period within 1950-2005, the very worst you would have done was +7.9% annually while the best was +17.2%. However, for a 1-year time horizon, the possible returns vary wildly.

Managing Risk

Managing risk is not only about reducing the risk from investments but matching your risk profile and time horizon to the type of investment portfolio that you will hold.  It would not make economic sense to have an investment portfolio of growth stocks which have higher degree of risk if your profile is that of a conservative investor or short time frame of investment.  It is also about protecting your investment capital and profits by reducing the potential for loss before it occurs.  

Risk cannot be eliminated completely  but can be controlled.  There are many options to manage your risk, from bonds to derivatives, but   assessing risk is not easy to as there are many different methods of evaluating risk.  The better option of managing risk, therefore, is to diversify your portfolio.  Diversification can be through many different classes of assets/investments.  The composition of your portfolio should reflect the level of risk that you are willing to take.  As your risk profile changes with time and growing needs, its important that you monitor your investment portfolio to reflect these changes.  Managing risk has to be dynamic. 

Risk & Time Horizon

The time horizon over which you will build up and hold your investment, a period likely to be determined by your age, play a significant part in how you allocate your  portfolio.  If you are in your 20s and 30s investing for retirement or put your child through higher  education, you should preferably invest in Equity Fund as your holding period will be 20 years or more. If you are nearing retirement, you should invest substantially in Bond Fund which gives a predictable return.

Risk & Investor Profile

One of the most principal tenet for investment returns is that they are related to the risk you are willing to assume. Higher the risk, higher the returns.  Thus it is of paramount importance that you rate your personal risk profile before embarking on any investment plans.  You need to explore your feelings, attitude and approach to money to work out an effective financial strategy.  You are more likely to follow a plan of action that suits your changing needs and preferences.  Investors are generally classified into five categories:  

Conservative Investor: Risk must be low and willing to accept lower returns to preserve capital.
Cautious Investor: Risk must be low but seek a better than basic returns.
Prudent Investor: Willing to accept calculated risk that will cope with the effects of inflation and tax.
Assertive Investor:  Accepts higher risk for capital growth.
Aggressive Investor:  Accepts highest risk for higher long term equity gain.