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Its-YOUR-money looks at Growth

We've talked a bit about the risk that inflation and economic growth will reduce the value of our savings. Inflation reduces the spending power of each unit of currency by increasing the price of many of the things we rely on in everyday life. Economic growth does a similar thing: by making most people richer, economic growth bids up the prices of things that are in fairly short supply (housing is the obvious example). Market-based real investment assets such as property are risky in the short-term because prices fluctuate so much from day to day, but as time goes on they follow an upward trend. That trend is the growth of the economy.

Real terms v. money terms

You will see me refer to growth in money terms and real terms. When we talk of growth in money terms, we don’t take any account of inflation. For example, a house that would have cost us £1,458 in 1946 would have cost us £101,550 in 2000. A basket of groceries that cost us £1 in 1946 would have cost us £26 in 2000. But somebody earning £1,000 in 2000 would have been earning around £10.45 for the same amount of work in 1946. These comparisons are all in money terms.

Obviously things are not the same in many other ways apart from the money. Our houses and groceries are not exactly comparable between 1946 and 2000, and nor are jobs. But in general, we are better off today even though things sound a lot more expensive when we look at what one pound would buy then compared to now. Although our groceries might be costing us around 26 times as much as they did 60 years ago, we are something like 100 times better off. Because inflation affects virtually everything to do with money, when we look at trends we take out the effects of inflation and talk in real terms. In real terms, our £100,000 house today would have cost £47,500 back in 1946.

The effects of growth in real terms

If we look at what has happened to the economy (which is a measure of how wealthy we are as a country), to financial assets (in this case the FTSE All share index) and to house prices we see that they have all grown at pretty much the same rate. (The graph covers 1946 to 2000, but the same happens if we go back a lot further). What you will also see from the graph is that whilst houses and shares have followed the same long-term trend as the economy, there have been some huge short-term variations. For example, the FTSE 100 share index is 4,980 today (February 2005). That is the same as it was in September 1997, and in the meantime it has been as high as 6,900 and as low as 3,300.

Investments that have a link to economic growth and inflation are good if you take a long view, but can be very risky over shorter periods because you can actually lose money if you have to sell them. House prices peaked in real terms in 1973 and didn't pass that peak again until 15 years later. Share prices peaked a year before (1972) and took 20 years to recover. It’s important to realise that you would still have made money in the meantime from rents (if you had houses to let) and dividends on shares, but you would have lost capital in real terms if you had sold the investments. It’s also important to bear in mind that we are talking here about houses as a whole and shares as a whole. There will be individual properties and companies that will have done better – and worse – than the trends suggest. And of course the benefits of economic growth are not shared equally either. There are always winners and losers.

The pages that follow look at these various aspects of investment in more depth.

 

  9 October, 2008 © 2008 K.R.Wade and Co Ltd prev page next page