Corrosive effects which rob us of our hard-earned cash

THE latest inflation figures make unhappy reading. While not at the eye-watering levels of Zimbabwe, where annual inflation is running at 11 million per cent, the UK's current annual rate of 5 per cent is the highest since the early 1990s. Steep price rises, particularly in food and energy, are squeezing household spending budgets.

But it is not only spending that is affected by inflation. After 15 years of benign inflation, many of us have forgotten its potentially corrosive impact on our savings too. So it's worth reminding ourselves what inflation means for investors.

As the American humourist Sam Ewing put it, "inflation is when you pay $15 for the $10 haircut you used to get for $5 when you had hair". Inflation is all about purchasing power: what the pound in your pocket will buy. The £5 that once paid for an entire haircut soon only pays half the bill, and finally only one-third.

So, as investors, we should be interested not only in the monetary, nominal returns of our portfolio, but also the real returns – what the portfolio value will buy in the future. Real returns are calculated by adjusting the nominal return for inflation. Just as a pay rise of 3 per cent when inflation is running at 4 per cent leaves us worse off, the return on our portfolio must exceed the rate of inflation if we are to be better off in real terms.

For example, an investment returning 20 per cent a year in nominal terms might sound very tempting. But in 1975, when inflation was running at over 24 per cent, any investment that was not returning more than 24 per cent was actually losing value in real terms. And keeping pace with inflation is particularly important for everyone with liabilities which are linked to inflation, such as living costs in retirement, or school fees.

Even low inflation can still make a hefty dent in purchasing power. Over the 15years to 2007, inflation averaged only 2.7 per cent a year, but this still meant that prices rose 50 per cent over the period. In periods of higher inflation, its impact is deadly. Over the 40 years to the end of 2007, prices rose 13-fold. That meant that, by late 2007, each pound in your pocket could only buy one-thirteenth of what it could in 1967, and was worth less than 8p in 1967 money.

So is it possible to "inflation-proof" your portfolio? Certainly some categories of investment are better suited to withstanding inflationary pressures than others.

In general, an asset whose value may reflect price trends will provide greater protection against inflation than an investment whose value is fixed in monetary terms.

Some investments are explicitly inflation-proofed, with their return linked to an inflation index. Index-linked savings certificates from the government-backed National Savings & Investments (NS&I) has a fixed term – currently three or five years – and their return is based on an interest rate plus the rate of inflation. An added bonus is that income on these certificates is free of tax.

Similarly, index-linked gilts (ILGs) issued by the Bank of England also provide explicit inflation protection and tax advantages. Both income and capital are linked to the retail price index and capital gains are tax-free. Note that the inflation-protection characteristic of ILGs makes them very different from other types of bonds. For most bonds, the returns are fixed monetary amounts, and their resultant inability to keep up with unexpected inflation is their greatest disadvantage.

Equities also offer long-term protection from inflation. For the whole economy, corporate revenues, costs and profits all rise with inflation. Equities provide a share in the ownership of companies. Consequently, the income from a diversified portfolio of shares should also keep pace with inflation. This characteristic is one of the most attractive features of equities. In the 40 years to the end of 2007, while prices have risen 13-fold, the capital value of UK equities (.excluding dividends) has risen 27-fold.

Of course, for most of us, the investment representing our biggest asset also happens to offer inflation-proofing – our home. Astonishingly, house prices have increased 48-fold in the last 40 years. Despite current difficulties, home ownership remains a sensible and tax-advantaged investment.

Finally, while there are other types of investment that may provide inflation protection – including gold and other commodities, art and wine – these sectors are more speculative. Anyone considering such investments should seek specialist advice.

In contrast, all investments whose value is fixed in monetary terms struggle to keep up with unexpected inflation. Falling into this category are cash investments – whether stuffed under the mattress or deposited in the bank or building society – and conventional bonds.

Unsurprisingly, the same general principle applies to various forms of income too: while workers usually see their wages rise in line with inflation, people on fixed pensions see the purchasing power of these pensions eroded by inflation over time. Pensioners in the 1970s were hit particularly hard by rampant inflation in that decade.

Of course, despite recent rises, we are nowhere near 1970s rates of inflation.

But, as we review our portfolios, we need to bear in mind inflation's potentially significant impact, whether or not we still have hair.

FACT BOX

Protects from inflation:

NS&I Index-linked savings certificates.

Index-linked gilts.

Equities (shares).

Property (home ownership).

Eroded by inflation:

Cash.

Bank and building society deposits.

Conventional bonds.