What are the consequences of inflation for your purchasing power?
Inflation and purchasing power are two terms that constantly crop up when talking about the economy and your portfolio. The terms are, therefore, clearly linked. But what exactly is inflation and how does it affect your purchasing power? We explain this to you below in plain language.
What is inflation?
Inflation simply means that prices rise in general. The rate of inflation is usually calculated by adding together the prices of a virtual shopping basket containing items that represent an average person's spending (food, energy, holidays, etc.). If that basket cost 100 euros last year and you are paying 102 euros for the same basket this year, it means the inflation rate is 2%. Because you need 2% more money to make exactly the same purchases.
What are the consequences of inflation?
A little inflation – about 2% – is good for the economy. Prices that are rising a little each year keep the economy going. Businesses and the self-employed can adjust their prices to take account of such a slight increase, consumers continue to spend money, and interest rates remain at a healthy level.
The less good news is that your purchasing power reduces because of inflation. Say you leave 100 euros in your savings account for a year, and that the inflation rate is 2%. In that case, next year you will be able to buy about 2% less than you can today with the same 100 euros, because the current low interest rate on savings accounts is not enough to compensate for inflation.
How can you protect your purchasing power from inflation?
As you can see, inflation nibbles away at the value of the money that you don’t spend right away, such as your savings. And savings accounts are precisely where most people in Belgium like to put away their money. There are good reasons for this, of course: a savings account is safe and simple. The government protects the money in savings accounts (up to 100 000 euros) and you can transfer money to or from it at any time.
However, whilst it’s true that you cannot lose money held in your savings account, the value of that money can shrink. And that can happen faster than you might think. Because even with ‘normal’ inflation of 2% per year, you will have lost 10% of your purchasing power after just five years.
A savings account is therefore not a good way to protect your purchasing power against inflation. To do that, you need to make your money work for you, so that it generates a return that at least matches (and preferably exceeds) the rate of inflation. One way of doing that is by investing.
Investing to counter the effects of inflation
When they hear the word ‘investing’, many people think it’s something that only wealthy people can do. Or they think you have to learn about the stock market, and even then you can still lose all your money. Yet it doesn’t have to be like that at all. There is of course a certain amount of risk associated with investing (it's what gives you the chance of higher returns), but there are a number of ways to keep that risk in check:
- By starting with small sums of money (at KBC, you can even invest your spare change)
- By investing periodically (for example every month), so you’re not dependent on the ups and downs of the stock market
- By trusting the fund managers at KBC Asset Management (they use their expertise to manage your funds)
- By thinking long-term – historically, the stock market has many more good years than bad, so it often pays not to sell too soon and to just sit out less good periods
- By having your investment profile determined, if you wish, so you receive investment proposals tailored to the level of risk you’re comfortable with
To summarise: With the money in your savings account, you can be sure of not losing a single euro. But at the same time, unfortunately, you can be sure that the same amount of money will buy you less each year. By investing carefully, you try to compensate for this effect of inflation by generating a higher return. See how to do this by checking out these three forms of investing for beginners.