Why the interest in interest?
Interest is tied to the cost of money. Even if you are using your own money, the cost to get that money is in time and effort. When you use other people’s money, such as loaning form a bank to buy a car the cost of money includes the interest you pay the bank for that money.
Interest is the return on the money. If you are using your own money instead of putting it into a savings account, you are foregoing the interest you could make on it. Money has a value and ideally should be able to create value. To create that value means we have to look at risk. Risk is the chance you take that things could go wrong and you cannot do what you want to do with that money.
Risk can be measured in financial return as well as financial loss. All people who lend money to another, wish to get rewarded for the risk they take. While the money is used for one thing, it cannot be used for another and this may mean you lose money because your capital is tied up. In finance we have to look carefully at how much return we wish to take for the risk. An investment that has no risk tied to it, (no chance of loss) is the benchmark we use. The rate we can earn on a no risk investment is called the risk free rate and this is used as a base to measure return.
The return on capital is called a risk premium.
A no risk asset is an asset which exists only in our minds in reality. In investment, however people believe the chance of getting their capital (amount invested) back when they invest in certain assets is extremely high. Normally these assets comprise of government bonds. If an investor could earn a 5% return on a government bond ( the risk free rate) then the more risky company stock should yield a 5% return plus an additional return (the equity risk premium) in order to be worth the risk of investing in that asset.
This risk we want to be rewarded for, is that we may not get some or all of the amount lent back and the reward is the risk premium.
Banks and cash deposits get rewarded with interest. Interest payments are normally determined by the central bank which sets the rates at which the banks can loan money, called a repro rate. The Central or Reserve Bank of a country is also called the bank of last resort, because this bank will loan money to banks to keep them solvent. As a result, banks have a low risk premium because they are not considered to be risky investments. The result of this thought process is that the Banks or cash investments, rarely outperform equities and properties. Bank deposits normally do not match inflation.
Equities are an investment in company shares. Property may be a direct investment in a house you live in or rent. Property may also be investing in a professionally run portfolio or business and farming land and buildings. Equity and property are rewarded in two ways, the first is the dividend income or rental and the second, the capital growth.
Understanding this relationship is important, because when a person saves money they wish to create wealth. If we do not outperform inflation- in other words get a return that is higher than the inflation rate then we are wasting our time. If our risk premium (return) on our money does not allow us to keep income parity (buy the same items in the future) going forward, then we should spend the money rather than saving it.
Inflation is the costs of an item now, versus the cost of that same item at a later point in time. For example if you live in Zimbabwe, a day could be an inflation unit, as a loaf of bread may cost 30% more by the next day due to the exchange rate. As a nation Zimbabwe is one of the poorest countries in the world, the economy is in tatters and basically the country is bankrupt. For Zimbabweans saving money may not be a wise thing to do, as the uncertainty of price means if they have sufficient money to buy an item now, it does not translate into having sufficient money to buy the same item tomorrow.
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In October 2018 cooking oil was on short supply in Zimbabwe. A truck load of oil came into a supermarket. People bought the oil. Why was this unusual? Because the price of a two-litre cooking oil bottle of $2, 75 in September went to a price of between $3.50 to $4, which is an increase of up to 27- 45% percent in a month. Zimbabwe also increased the price of fuel- this meant the price of oil would likely rise again in the next month. Let us have a look at something we can compare. A loaf of bread in 2019 in this country of Zimbabwe in January 2019 would cost you $1.40, (R 18.00) in February 2019 the same loaf would be available at $2.10 (R 31. 00), or a 67% increase. Now let’s compare this inflationary increase in Zimbabwe to price increases in the USA. In January of 1988, the United States Department of Labour, Bureau of Statistics, indicates that a loaf of white bread cost approximately 59¢. In January of 2013, that same loaf of bread cost $1.42. We can use these figures to work out the cost of a staple diet ingredient. If we do that then the inflation rose by 140% in 25 years giving us an average inflation rate of 5.6%. |
The example above is not meant to give inflation rates of a country on simply two items, but to demonstrate how price increase will impact on savings. For savings to have a value to a person they must be able to have a certainty that they can beat inflation. In Zimbabwe, it is unlikely an investment could keep up with inflation, unless the risk premium or reward for saving is higher than the inflation rate. This is unlikely so the person would rather buy the bread today and eat it.
In the USA, the person would consider investing, in 1988, in the knowledge that the 59c would have a potential to grow sufficiently to buy at least the same loaf of bread in 2019. To do that they would want a rate that is in excess of the average inflation rate of bread. In other words a return of at least 5.6% per annum.
Keeping up with inflation when a person retires is important as retirees do not expect a pension increase per annum that will be in excess of inflation. As a result it helps to understand another financial term called the Price Index value
Since Inflation is broadly defined as an increase in the general price level, in order to accurately measure inflation for a period we must first assess the general price level. The general price level is measured by a price index.
To create a price index countries will take the price of a basket of certain goods and services. The price at that point is set down and forms the Consumer Price Index or CPI. The price of the basket at that point is set at 100. This basket of goods and services, now forms a reference point or a base index so we can say that should the basket cost 100 currency units in 2018, then if that basket goes up to 110 currency units it will push our price index up to 110 or 10% of the price index price. We can do this for other commodities too- housing, medical care- in fact anything which has a monetary value.
Index linking is extremely important to any business or country since it can give the wage rate or material costs adjusted in proportion to the change in some specified price index, the purpose being to maintain the real purchasing power of wages over the kinds of goods and services typically consumed by wage earners and forming a basis for pricing goods and services in the future. Without this price indexing, organisations would not know how much a reasonable increase in wages or pensions is per annum.
Price indexing becomes a wonderful tool for retirees to use too, because they are often publically available at no charge thanks to the internet.
The next thing we can do is take that same basket of goods and use it to compare the cost of living in other cities or countries. Now this would involve a lot of travelling and would probably cost us too much to do, but can you can see why this could be valuable to us as retired persons?
Fortunately there are companies that calculate these types of “Price Index values”. These companies will assigning a value of 100 to a central reference city. Once the reference point has been established, the Price Index value of every other city in the database is calculated by comparing their cost of living to the cost of living in that city.
Therefore, if a city has a Price Index of 134- it means that living there is 34% more expensive than living in a country that has a price index of 100. For a retired person this information can be used to determine where they should live. Just by using this information you can increase your pension by moving to a cheaper area, or even country to maximise “the spend” of the pension-i.e. buy more goods with the same amount of money.
There are many different price indexes that are used throughout the world. One of the most widely known is the Big Mac index. The Big Mac is selected for comparison as the popular fast-food meal is widely available across the world, and remains fairly consistent in pricing. The use of the big mac pricing is also called ‘Burgernomics’. We can use this to calculate what the exchange rate should be in order to buy the same meal at different locations across the globe. I have put some sites down in our references at the end of the book to help you in this matter of price indexing.
Currency rates pay a large role in the cost of goods for the local population if items. A currency is considered undervalued, when its value in foreign exchange is less than it “should” be based on economic conditions.
The reason currency is so important is because we live in a global village and our goods will be sold according to the best price we can get in that global village. A country will not want to import an item it can create cheaper on its own soil, unless other factors are present. Factors can be perceived value, or such name brands which are recognised as giving value. This value does not have to be purely economic, it can have a social aspect as well. For example, a Burberry scarf does not keep a person warmer than a woollen scarf, but the distinctive Burberry pattern is perceived to be more glamorous. We call this value branding. Importantly this will impact on the more socially conscious retiree, as their cost of living may increase, due to them requiring other services such as podiatry or dental work.
Currency is also important for our local producers, as they will actively search for areas they can sell their goods at a higher price than locally. The cost they receive for the goods should be higher than selling locally, after factors such as transport, marketing, distribution and administrative expenses are taken into account. We call this value adding. If the currency allows them to get a higher price offshore then shortages will occur in the country as producers are profit driven- or look for the best price.
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Currency risk- where will we be? What are the risks in a Rand based cash investment for a South African investor? A number of South Africans have lost their children to other countries. Meet Bheki and Rebeca. Their beloved son and daughter are in Australia and the UK respectively. Both children have married citizens in these countries and grandchildren have been received. Bheki has done well as a municipal worker and has retired with a pension sufficient to live in reasonable comfort, but not well enough to afford the airfares and visa costs to visit his grandchildren. Rebeca has to make do with skype calls, but would love to be able to kiss and cuddle the two babies. Currency plays a large role in the two Grandparents lives, a small gift can cost a large local Rand value in comparison with two very strong currencies. Their financial advisor has tried to create an overseas investment for them in this regard. Because the foreign investment earns returns in the countries’ currencies the Rand exchange rate is not a major factor. The returns will keep up with the needs of the couple to be able to give occasional gifts. Bheki says it is sometimes hard to accept that when the South African currency depreciates and he has been able to visit his children (they try to see the family every second year) that he cannot afford to contribute to the family or take them out to a meal without severely impacting his ability to survive on his return home. The foreign investment although small has helped immensely. His children contribute to visa costs and airfares where they can. Would the couple move countries to be with their children given the chance? They would, but both agree the thought of being effectively dependent on the kids is distasteful to them. Their hope is that South Africa will improve to an extent that the children will be able to return to a country they are proud off once again. It is sad to see such loving parents alone, effectively imprisoned by currency. |