How to stay ahead in the inflation game
In investing we often overestimate the impact of some factors and underestimate the impact of others. For example, for someone saving for retirement, the level of savings (as a proportion of their salary) is far more important than their investment return in the early years (we often put far more emphasis on the investment return).
Inflation is one of those things we massively underestimate; it slowly eats away at our wealth year after year without us really noticing.
Reimbursing my daughter for a McDonald’s meal recently, I was amazed to hear that a medium quarter pounder meal now costs €9.60, I still had it in the category of circa €5.
But it makes sense. The costs for McDonald’s have all gone up with inflation (the burger, the bun, the ketchup, staff, etc.). McDonald’s have pricing power and so can push through the increased input prices into the price of the meal. This increased price results in higher revenue and profits for McDonald’s, which should ultimately end up in the share price. McDonald’s share price over the past 5 years is up 60%* (capital & dividends) whereas inflation over 5 years is up circa 23%* (correct as at December 2024).
On a global basis, the best way to keep up with inflation is to invest in global equities.
Companies with strong pricing power, like McDonald's, can pass on higher costs to consumers. However, not all businesses have this flexibility—some industries struggle when input costs rise faster than revenues. Therefore we’re better off removing this risk and owning everything (a diversified global equity portfolio). In the US over the last 50 years, equity returns have averaged 10% per annum, while inflation has come in at circa 3%.
The other key thing about inflation is your personal level could be a lot higher than the economy-wide one. For example, housing and electricity costs have been well ahead of general inflation in recent years. The impact of inflation is impossible to disregard.
To combat it is not simply a matter of buying equities and expecting them to rise in tandem with inflation. Inflation is like the pacemaker in a middle-distance race. It starts strong, sometimes pulling ahead by a significant margin. The rest of the field – representing the global stock market – eventually closes the gap and crosses the finish line first. It’s a race that requires patience.
As a practical example (using US data as it’s readily available*), if we take the McDonald’s meal that we spoke about earlier, in 1998 this meal would have cost apx. €5. If that €5 had been invested instead it would now be worth around €31.50, enough to buy three McDonald’s meals today. On the other hand, if the €5 had just been kept in a wallet, it would now be worth less than half the cost of a single McDonald’s meal. The same principle applies across restaurants, holidays, energy costs, etc...
While equities do come with volatility (experiencing significant fluctuations over time), over the long term they have proven to be the best way to protect against inflation. We therefore have a choice to make: should we put up with the volatility (with a sensible allocation to lower risk assets to cover short term needs) or are we happy to consume less in the future? Ultimately it is a trade-off; we choose where we take our pain.
*US data