'INFLATION HAS gone up (again), and interest rates are down'
The keen investor hears this news and, like the announced interest rate, his heart plummets in his chest as he considers the many challenges.
In an environment where inflation is higher than interest rates, investors will experience negative real returns.
The operative word is 'negative' as this means that the value of the investor's money will have a lower purchasing power than it did before, and he will be losing value from investing in that option.
For example, Sharon, the avid investor, has a savings account at a commercial bank from which she receives an interest rate (nominal return) of nine per cent per annum.
However, the current inflation rate is 11 per cent. This means that Sharon's real return is actually nine per cent less 11 per cent which results in a negative two per cent.
Real return is a function of inflation given by the following formula: real rate of return = nominal rate of return minus inflation rate.
Sharon's money is, therefore, losing value on that investment option by two per cent.
The race to stay ahead of rising inflation and declining interest rates is not for the faint of heart and requires strategic planning that is based on a keen understanding of how the economy and the money market works.
Your JMMB financial planner may suggest the following based on your personal financial assessment:
Keep your money in investments that do not fluctuate in value, and wait for the interest rate to increase or inflation rate to decrease.
Find an asset class that is performing better than inflation (meaning the rate of return on that asset class is higher than inflation rate).
In this case, stocks are a good example. However, for the short-term investor this might not be the case. In that event, one could explore other asset classes such as investing in currencies or commodities.
The diversified portfolio approach however ensures that all your funds are not invested in one asset class. Asset classes such as bonds and stocks usually perform positively during declining interest rates, as there is an inverse relationship between bond prices and interest rates and stock prices and interest rates.
Similarly, when interest rates decrease investors in an attempt to seek higher returns, invest more in stocks which usually causes an increase in stock prices. Because there are several factors that affect stock prices, this is not always the case.
THE VALUE OF A
DIVERSIFIED PORTFOLIO
Diversification is a portfolio strategy designed to reduce exposure to risk by combining a variety of investments, such as stocks, bonds, and real estate, which are unlikely to all move in the same direction.
The goal of diversification is to reduce the risk in a portfolio. Volatility is limited by the fact that not all asset classes, industries or individual companies move up and down in value at the same time or at the same rate.
Diversification reduces both the upside and downside potential and allows for more consistent performance under a wide range of economic conditions
Benefits of a diversified portfolio
Reduces risk, volatility
Provides higher returns in the long run (depending on starting point)
Used as a hedge against inflation, currency risk, etc.
Achievement of goals sooner
Better investment management
Various investments provide, liquidity, income stream, capital
In the face of these declining rates, JMMB financial planners consistently seek innovative and strategic plans to protect your investment.
Each plan is comprised of a diversified portfolio.
Central to this effort is JMMB's guiding principle to educate clients on the benefits of diversification.
There are a wide range of products across the major asset classes which clients can choose including the money market, bonds, stocks, insurance and investments in major currencies (J$, U.S.$, GBP, euro).
However, having a clear understanding of these options is critical.
Financial consultations are offered free at JMMB as they help you manage your finances throughout your financial life cycle.
Next week, we will explore the benefits of international expansion.
Feel free to email comments to Catherine_davis@jmmb.com.
