|How does ‘inflation hedge’ affect me? - Jun 3|
|Series - ASK NICK|
|Saturday, 02 June 2012 23:00|
I keep hearing the expression “inflation hedge” from the financial gurus in the newspapers, could you explain what this is and if it has any bearing on my life?
This is a most important concept that affects everyone. Think of what a hedge is supposed to do. Its main job is to protect a property from intruders. So in this context you can say it is a form of protection of your assets from the ravages of inflation.
Inflation is the rising cost of living and can be thought of as a phenomenon - no one thing can be directly held responsible for its existence.
You may have heard of “cost push” and “demand pull” inflation.
Cost push Inflation can be seen for instance when the factors of production that go into making a product or service increases. These factors include but are not limited to: wages, fuel and rent. As the costs of these things go up they push up the prices of goods and services.
Demand Pull Inflation can be seen when there is a lot of money circulating in the country, for instance when petroleum revenue increases causing government spending to increase or when government workers get a massive back pay and that money enters the system. Remember the saying “have money will spend”? People with more money will spend more on goods and services. If demand increases and there is not enough supply to satisfy that demand, then naturally prices escalate because of the relative scarcity of things.
Of course the above is a very simplified explanation of how inflation works but the reality is, it never stops – things just keep going up and up.
Unfortunately not everything moves in the same direction or at the same speed as inflation. Consider how fast your income or value of assets increase – are they keeping pace with the cost of living? If your assets or income are not increasing, then you are losing value and buying power.
You may have seen this when you go to the market. When I was in my teens I remember coming home from the market straining with two big handle bags stuffed to capacity after spending just $40. Today when I spend that same amount of money I find myself taking away a light, white, plastic bag on my little finger.
So how do you protect (or rather build) an “Inflation Hedge” around your assets and income? Both your income and your assets need to increase at an equal or greater rate than inflation.
Let’s use the example of a property. You decide to acquire a property to help you in retirement – a time that you feel inflation the most, when you begin living on a fixed income (pension) for the rest of your life.
As demand for accommodation increases there is competition for the limited supply of places to buy or rent. This causes the prices or values of properties to increase and hence the levels of rents to follow. As such a property used for a retirement income is an excellent Hedge against Inflation.
There is a third benefit of owning property in the context of increasing prices and that is – it can be used to supplement your food bill. Consider planting fruits and vegetables on some part of your property to gradually eliminate the financial strain from lifting that light bag coming home from the market.