Investment vs inflation risk: the importance of staying invested

Investment risk, often measured in volatility, is the flip side of returns. So in a benign market environment, when things are going well, volatility is your friend – you receive a reward for the risk taken. But in a malign market environment, when things are getting difficult, volatility is your foe – you receive a negative return for the risk taken.

Higher risk assets such as equities may appear volatile and will fluctuate. However, in an inflationary regime, they are safer than cash over the medium to long term.

By the same token, lower risk assets such as cash may appear safe and not fluctuate, but in an inflationary regime cash is high-risk over the medium to long term as its purchasing power is destroyed by inflation. 

The volatility of cash is not, in fact, zero, but is impacted by the volatility of inflation. And when inflation volatility is high, the riskiness of cash is high. In this respect, understanding the difference between investment risk (volatility) and inflation risk (loss of purchasing power) over time is key.

Equities vs cash in an inflationary regime

By way of illustration, we can look at the relative performance of equities (we use S&P 500 in GBP terms as a proxy) and cash during the period of high inflation in the UK from December 1972. 

Over five years, an allocation to equities delivered a price return of -1.3 per cent (-0.3 per cent annualised) while cash lost -54 per cent of its purchasing power (14.2 per cent average annualised inflation).

Staying invested and allocating to equities can deliver preservation of purchasing power and capital growth.

Over 10 years, an allocation to equities gave a price return of +72.9 per cent (+5.6 per cent annualised) while cash lost -73 per cent of its purchasing power (12.4 per cent average annualised inflation).

And over 20 years, an allocation to equities delivered a price return of +473.7 per cent (+9.1 per cent annualised) while cash lost -84 per cent of its purchasing power (8.8 per cent average annualised inflation).

What we see is that staying invested and allocating to equities for the short, medium and long term in an inflationary regime can deliver preservation of purchasing power and capital growth.

Understanding the concept of equity duration

What do we mean by equity duration? In technical terms, the duration of an equity is the sensitivity of the price of that equity to any change in interest rates.

More practically, equity duration can be defined as the number of years it takes for an investor to recoup the price paid for a share from cash flows generated by that same share, that is, dividends.

The fall is greater for long-duration equities than it is for short-duration equities.