Are my investments keeping up with inflation?

Inflation is an increase in the price of goods, services and other things we buy. In Canada, we measure inflation with the Consumer Price Index (CPI). Think of the CPI as a "basket" of things the average household buys. The CPI is divided into eight major categories. Here we show the weights of each category in 2021.

The CPI is based on the average spending habits of a large number of Canadians. Each person or family is unique and will have their own inflation rate, based on how they spend their money. For example, Canadians whose homes are paid off might not feel much inflation from shelter. Similarly, those who like to walk instead of drive might not feel much inflation from transportation. 

Let's look at how inflation affects investments. Say your investment balance increases by 8% in a year. You start the year with $100 and end the year with $108. We call this the "nominal" return on your investment, before inflation. 

Now let's say inflation is running at 3%, so prices have gone up from $100 to $103. How does this work out?

Sure, you have $108 but now your goods cost $103, so your purchasing power has only gone up by $5. This is a 5% increase in the purchasing power of the $100 you had at the start of the year. We call this the "real" return on your investment, after inflation.

Next time you hear about an investment return, keep it "real" by asking about the return after inflation. To get the real return, take the nominal return and subtract inflation.

In our example, 8% nominal return minus 3% inflation equals a real return of 5%. Think of real return as, "OK, but what can I really buy with that?"

Long-term investors should focus on the real return a lot more than the nominal return, since the purpose of investment is about being able to buy things in the future.

Thinking about your investments in "nominal" and "real" terms — before and after inflation — is one of the most important things you can do as a long-term investor. Next time you meet with your advisor, ask about the rate of inflation that's assumed in your financial plan. Discuss whether this rate still makes sense and see what it means in terms of funding your goals.

Whether you're investing for retirement, your children's education or a dream vacation, including inflation in your financial plan will give you a clearer view of what really matters about your investments: what you can buy.