Asset Allocation: Risk and Return : Inflation

Next, we need to consider inflation. What we have been talking about so far are what are called nominal returns; that is, returns that don’t take account of inflation. But how useful is this?

Think about it this way: If you invest $1000 in year 1 and 5 years later that investment has grown in value to $2000, you have realised a 100% increase in your purchasing power. But what if prices have increased by 100% as well. You will have realised no increase in purchasing power at all.

Of course, if you had not invested the $1000 – if you had just stuck it under the mattress – inflation would have actually reduced the real value of your money.

So, if you keep pace with inflation, at least you maintain your purchasing power.

But you get the point. A realistic assessment of an investment's returns has to take account of inflation. So when we start looking at asset class performance we will be looking at real returns, not nominal returns.

OK, so we know what an asset allocation strategy is and, in the concept of an average annual real rate of return, we have got our first useful tool when it comes to making meaningful judgements about the returns offered by an asset. Now let’s look at the historical return characteristics of the key asset classes.