Whether you’re saving for or living in retirement, it’s important to be aware of inflation risk – that is, the risk that inflation will erode the value of your investments over the long term.
Put simply, inflation is the general rise of the price of goods and services over time, which reduces your purchasing power.
Inflation can eat away at your investment returns, so it’s important for your wealth to grow at a faster rate. Fortunately, there are ways to mitigate the impact of inflation on your investments.
Source: Bank of Canada, Average annual rate of inflation
By building a diversified portfolio with the appropriate amount of equities and fixed income, your portfolio can potentially grow at a faster rate than inflation and help build wealth. Historically speaking, equities have delivered higher rates of return than other asset classes over time. Over the past 20 years both the S&P/TSX Composite Total Return Index and the S&P 500 Total Return Index posted average returns that outpaced inflation.
By investing in equity funds, you can benefit from the capital growth of the underlying companies, as well as any dividend income. It’s important to remember though that investing in equities involves higher risk than fixed income or cash, so take care to add only as much equity risk as you can handle.
Although less dramatic, fixed income can also help preserve capital. Over the last 20 years, fixed income investments have also outpaced inflation and provided worthwhile capital appreciation. Fixed income investments are not all created equal, and therefore it is important to hold a diversified mix of fixed income investments in your portfolio. Each segment, however, reacts differently to changes in interest rates, the economic outlook and other market factors. There are specific risks involved in fixed-income investing, so ensure you work with your advisor to choose investments suitable to your risk tolerance and investment time horizon.
Source: Morningstar Direct, Bank of Canada, RBC GAM. 20-year data as of December 31, 2020. For illustrative purposes only. Equity returns consist of capital gains and dividends; bond returns consist of capital gains and interest payments; T-bills are represented by FTSE Canada 91 day T-Bill Index. Bonds are represented by FTSE Canada Universe Bond Index. Equities are represented by S&P/TSX Composite TR Index. Capital gains are deemed to be realized on December 31, 2020. The indicated rates of return are the historical annual compounded total returns for the periods indicated including changes in unit value and reinvestment of all distributions. Index returns do not reflect deduction of expenses associated with investments. If such expenses were reflected, returns would be lower. An investment cannot be made directly in an index. Inflation is approximated by the change in Consumer Price Index (CPI) each month.
In this era of low interest rates, it is important to incorporate strategies that are designed to help the growth of your investments outpace inflation.