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What is inflation?

What is inflation?

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Inflation is defined as a sustained increase in the price of goods and services. It is measured as an annual percentage increase. In other words, inflation means that it costs more to buy the same goods/services this year than it did in previous years, or the same amount of money this year, buys fewer goods/services than it did in previous years. 

The South African Reserve Bank (SARB) has set a target band for inflation in South Africa of 3-6% per annum. However, this is just the average level of inflation in the economy for a specifically defined basket of goods consisting of food, electricity, fuel and transport costs etc. The actual level of inflation that an individual experiences will differ from person to person, depending on the items in your particular basket of goods. 

For example, an elderly person will feel the impact of an increase in healthcare costs much more than someone who is young and relatively healthy. Increases in the cost of education will be a much more significant factor for a family with young children than a pensioner in retirement. 

Why does inflation matter to me? 

It is important that your income and investments keep pace with inflation to maintain your standard of living. If this does not happen, your real wealth and purchasing power will actually decrease over time. 

For example, if a basket of goods costs R100 this year and inflation for the next year is 6%, that same basket of goods will cost you R106 next year. If your income has not kept pace with inflation and you still only have R100 to spend, you will not be able to afford the same basket of goods next year – your basket will have to shrink i.e. your purchasing power will steadily decline over time. 

While we showed how compounding can be your biggest friend in investing (see “Best time to start saving blog”), inflation is your biggest enemy. When deciding on an investment strategy, be sure to consider whether your investments are likely to keep pace with inflation over time. 

The value of your investments over time – and their ability to outperform inflation and grow your real wealth - can differ vastly depending on the types of assets you invest in. Over the long-term, equities have provided the greatest return, but come with the highest risk. On the other hand, the risk of leaving your savings in a bank account for long periods of time, will likely see your real wealth being eroded over time. 

“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair” - Sam Ewing

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