February 9, 2016 - Latest:

# Inflation, compound growth and some lessons for investors

• 30 April 2013

Alan Easter, group chief executive of financial planning and investment firm the Beaufort Group, discusses the lessons he has learned about inflation and what it really means for investors.

I remember a time at school, sitting in a maths class when the subject of ‘compounding’ first raised its head. The example used by my teacher was one, which I am sure we have all heard; ‘if you place one tea leaf on the first square of the chess board, double it for every other square, how much tea would be needed by the last square?’.

We were all asked to guess without calculating the answer. Hands were raised, answers shouted and the teacher laughed. No one, not even the brightest is the class, came close.  The answer of course is…well, I’ll leave you to work it out but it is more tea than all the tea in China.

The exercise dramatically showed us the difference between simple and compound maths, a difference we all think we understand but mostly ignore until it impacts upon our daily lives.

But what is the point of this? Well, let’s start with basic money rules i.e. if you pay compound it is bad, but if you are paid compound it is good, great in fact. A very small compound number is normally more attractive than a high simple number, depending on the length of the term calculated of course. So, if you borrow, seek a low flat rate and pay it off as quickly as possible. If you lend (or invest) a small number that compounds up, it is great, once you leave your money invested.

The danger though will always be the underestimation of just how much ‘tea’ is needed at the end of the term. And the current economic climate is, I believe, leading to high error rates which will, in turn, lead to more than expected financial pain for many people.

Consider this; we live in a low(ish) inflation environment, interest rates are low, wage rises for some are non-existent and returns on cash are tertiary (some would say derisory). If the direction of travel, and the rate of ascent, was the same for all points of influence then everything would be relative and all would be fine.

But the issue is that, the influence points have started to pull away from each other and this causes error gaps. And as the gaps are compounded then even a small error rate can be catastrophic if not rectified quickly.

Let us use wages versus price increases as an example. The Office for National Statistics issues all kinds of interesting data (for people like me who took that maths class a bit too seriously) and one set of data recently published has been the divergence between wage growth and prices. As we know from the Bank of England, inflation is quite a way above the Government’s set target and whichever data set you subscribe too, the message is the same, it costs more to live now than it did a year ago.

In a more normal economic climate, this has been okay(ish) as employers usually dealt with this through pay increases that were either inflation or performance based. In fact, there was invariably a positive effect of the raise with more money being paid out in wages than inflation had eaten up with price increases.

Sadly, for workers, this has not been the case since 2008 when price inflation overtook wage inflation and this has been the case ever since. So, even though pay rises have been granted (the national average last year was less than 1%) the amount is not enough to keep up with price increases. Even a small difference, when compounded over years, will make a massive difference in spend-ability.

It was hoped this divergence would only be a short-term issue but with the current austerity package showing very little sign of easing off and corporates still hoarding cash and cutting costs, we should consider this, as being the situation for a long time yet.

Understanding compounding is a core requirement for even basic financial planning, self-selected or advised; the impact of price increases on a basket of goods at some point in the future is the spine of retirement planning; understanding the cost of provision is rising not just as an explicit cost, but also as a relative amount is something very few consider.

This website for the Beaufort Group is at www.thebeaufortgroup.co.uk

• Eric

But you missed an important factor, Alan – Time! Suppose the interest rate is 5% pa. To take your chess board example that means you can only move to the next square every 14 years (Money doubles every 14 years, approx. at 5% interest). Sure by the time you reach the 64th. square you’ll have a lot of tea leaves; but it will take you 896 years. After a lifetime, say 70 years, you’ll only have 32 tea leaves. The power of compounding as an exponential series becomes much more apparent the nearer you get to the end.