Consumer Price Index (CPI) And Investing

CONSUMER PRICE INDEX (CPI)

Who can benefit?

Everyone. An understanding of the CPI is important for measuring how well your investments really are performing, the amount of investment funds you will require to maintain your lifestyle in the long-term and how government benefits will increase over time.

What is it?

The CPI is a measure of inflation. A basket of goods and services is measured by a government department on a periodic basis. Most countries measure their inflation rate. In America it is theUS Bureau of Labor Statistics which is a monthly update while in Australia theAustralian Bureau of Statistics takes a survey every three months.

This basket of goods may include diverse items such as the cost of a loaf of bread, petrol, car registration and train fares. The difference in the total prices results in the rate of inflation or the change in the index. The rate is usually positive although short-term negative movements have occurred.

An example is useful. Let’s say the current basket of goods have an index value of 221. A year later the index is measured to be 233. The rate of inflation over this one year period is (233 – 221) / 221 = 12 / 221 = 5.43%. A rate of inflation over a one month period will of course be a much smaller figure, however this figure is usually given as an annualised rate to show the trend in inflation.

The basket of goods being measured will change over time to make it relevant. For example, the price of buggy whips and horse feed may have been important in 1920 but would not be included in the CPI of 2012.

What are the benefits?

The CPI may be used as a benchmark for the performance of your investments or the required performance to maintain your standard of living. If your income is not keeping pace with inflation then you will be unable to maintain your standard of living. Therefore an investment after taxation must return at least the CPI or your asset is losing real value.

Some investments, such as the income from an annuity, may be tied to the CPI so your standard of living is maintained. Other investments state their performance goal as a measure of CPI, say CPI plus 3%.

It is important to note that some investments do better than others during high inflation as compared to low inflation. Other investments do better when inflation is falling while some outperform when inflation is rising. For example, interest rates usually follow the inflation trend. As inflation falls bonds usually outperform, but under perform when inflation rises.

Example The “rule of 72″ is an easy way to determine how long (in years) a rate of inflation will cause prices to double. The number 72 is divided by the annual inflation rate. For example if inflation is 7%, prices will double every 72/7 = 7.2 years. It also works to show how soon a given rate of return will cause your investment to double in value.

Any downside?

The CPI is a basket of goods, which may have little relation to how you actually spend your money. Therefore, your personal inflation index may be far different from the official rate.

Benchmarking your investment against the CPI in isolation may be misleading. For example, the capital growth of your investment property may have outperformed the CPI by say 2% long-term. If the return increases to 4% above the CPI you may think that you are doing well. However if similar properties have outperformed by 10% during the same time period you have actually done poorly.

This is an amended excerpt from Financial Planning A to Z, to be published in late 2012. Refer my website www.barrylizmore.com.au for more details. Articles of a similar nature will be posted at the start of each week.