The widespread expansionary monetary policies of central banks, bottlenecks in supply chains, and the war in Ukraine, which has further increased energy prices, have formed a perfect cocktail for inflation to soar and close to double digits.
Annual evolution of the CPI nominal profitability
Source: National Institute of Statistics
In Spain, inflation reached 9.8% in March 2022. In Europe, it stands at 7.5% and in the USA it also soared to 8.5% in March .
Table of Contents
What is nominal profitability?
What is real profitability?
Formula:
High inflation reduces real profitability
In fact, the effect of inflation is always harmful to our pockets, no matter how low it is.
The cumulative effect of inflation
What is nominal profitability?
Generally speaking, when we talk about profitability, we are talking about nominal profitability. It is the profitability that we obtain from our investment without any other type of consideration or correction.
In recent years, talking about nominal profitability was not a chinese overseas canada phone number data problem, since we have experienced many years of very low inflation, many years close to zero or even negative.
But when inflation soars, it becomes important again to talk about real profitability and nominal profitability.
What is real profitability?
Real profitability is that which corrects nominal profitability for the effect of inflation. It consists of discounting the effect of inflation from nominal profitability to obtain real profitability, once the harmful effect of the loss of purchasing power caused by inflation has been discounted.
For example: if the nominal APR of an investment is 10%, but the annual inflation is 2%, the real annual return (or real APR) is:
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Formula:
(1+nominal APR)/(1+annual inflation)-1=real APR
Applied to this example:
(1+10%)/(1+2%)-1= 7.8%
That is, a nominal return of 10% becomes a real return of 7.8% with, let's say, moderate inflation of 2%.
High inflation reduces real profitability
The problem is that with high inflation real profitability contracts.
For example, with an inflation of 9.8% the real profitability applied to the same example above would be:
(1+10%)/(1+9.8%)-1=0.2%
As we can see, our nominal profitability, when converted to real profitability, has almost disappeared, it has been diluted by the effect of inflation.
In fact, the effect of inflation is always harmful to our pockets, no matter how low it is.
Many choose to worry little about optimizing their money and leave the money in current accounts or deposits at close to 0%. In these cases, even with a moderate inflation of 2%, the real profitability is negative if we continue to apply the formula:
(1+0%)/(1+2%)-1= -1.96%
What higher inflation shows is that real returns are even more negative for those who opt for 0% deposits or current accounts .
With inflation at 9.8% if we leave our money at 0% we would lose 8.9% following the formula:
(1+0%)/(1+9.8%)-1= -8.9%
According to Inverco data on the financial assets of Spanish households, deposits and current accounts continue to set records and exceed one trillion euros (specifically 1,015,070 million Euros in the third quarter of 2021) and account for 41% of Spaniards' savings. This figure is, in general, well above other European countries if we exclude Portugal, as we can see in the following graph.
distribution of financial assets nominal profitability
Source: Inverco with data from the Bank of Spain, third quarter of 2021
The cumulative effect of inflation
It should be remembered that the effect of inflation also compounds over time ( like the expenses of an investment ), multiplying exponentially the effect of depreciation of our savings over the years.
In the graph above on the left we can see how a saving of €10,000 with inflation at 2% already loses €1,797 and is reduced to €8,203 after 10 years. In the graph on the right we can see how with inflation at 9.8% inflation would eat up €6,074 of the value of the savings and we would only have a real saving or net of inflation of €3,926.
It is therefore advisable to look for alternatives for our savings. It is not about taking aggressive positions, but once we have established and know the amount of a reasonable emergency fund , it is advisable to look for efficient investment alternatives that allow us to avoid the erosion caused by inflation .
To help you in this search for alternatives, it is worth remembering that inbestMe's highly diversified portfolios are designed to adapt to any need and optimize your profitability based on your risk profile .
Let us hope that the war in Ukraine ends soon and that central banks find a way to control inflation.
