CPI AND INFLATION, WHY YOU CAN’T JUST KEEP YOUR MONEY IN CASH
The consumer price index (CPI) measures the cost of living in Australia, and inflation is the term used to describe the rise in the cost of living.
In basic terms, while $1 might have bought you a litre of milk 10 years ago, due to inflation, you will need $3 to buy that same litre of milk today. Or as my dad would say, you used to be able to get a potato scallop for 5 cents back in the day and he is outraged that he now has to pay $1. I know dad, it is an outrage!
I am guessing that if you are choosing to invest, you want your investment to grow in value over time. It is therefore important that the growth rate outpaces the growth in CPI, otherwise, while the dollar value of your balance may increase over time, the actual buying power of your investment may not.
When you hear investors or planners talking about ‘real return’ from an investment, they are talking about the return that is over and above inflation. So, let’s think about your current ‘high interest’ savings account. It is returning 3.5% per year, which is great. If CPI however is 3% for the year, then you have only earned 0.5% of real return. Now you will also be required to pay tax on that amount which could be as high as 45% of your profits.
With this minimal earning, you aren’t really giving your hard earned cash a chance to grow, in fact when taking into account tax it may be going backwards.
Self Managed Super Funds (SMSFs) are big business at the moment, but a recent study showed that many SMSF owners are holding very high percentages of their super money in cash. The job of a super fund is to grow and provide for your retirement, but if you have the money sitting in cash, you may only just surpass CPI, and that isn’t even taking into account tax.
Now I do believe holding a sum of your wealth in cash or cash type products is important for diversification and liquidity at short notice, but a well balanced portfolio will generally not hold your wealth in 100% cash especially if you are in an accumulation phase.
My general tip is to have 3 to 6 months worth of salary in a high interest or offset account ready to access should you need it (and let me tell you, it is likely that you will need it) and then carefully think about what you would like to achieve over and above this and then put your money to work.
For those who are closer to retirement or in retirement, it is not uncommon to hold a higher percentage of your portfolio in lower risk investments such as cash and fixed interest.
If however you are opening a SMSF to load up on cash and term deposits, then you might want to rethink your goals and personal situation, and think about the fees you are paying in order to hold your money in cash. SMSF’s aren’t cheap so you want to make sure your money is working for you.
– This post is from our resident senior financial planner, Cara Brett. Check out her details in our about us page.