Page 1 of 3

The how and why of investing in shares.

We New Zealanders love our bricks and mortar. After property investment, we've traditionally directed any leftover money into investments that are considered 'safest', like savings accounts, term deposits, and debentures.

Plenty of people still do, and it's unarguably wise to keep some of your money available in interest-bearing assets like these most of the time. But even though these investments are about as safe as you can get – you're highly unlikely to lose all or even part of your money – they carry other, less obvious risks.

The biggest of these is that interest-bearing investments alone will generally not help you increase (or even maintain) your purchasing power. And that's because they don't always provide enough protection against the two key 'capital gobblers' – inflation and tax.

While most investors spend their lives worrying about day-to-day fluctuations in share prices, housing prices, and so on, a much bigger problem for most people over the years has been the awesome corrosive power of inflation.

Albert Einstein may have claimed that compound interest was the greatest human invention but, when it comes to inflation, the compounding is working against you – all those two and three percents per annum really add up.

Even at relatively low levels, inflation's effect on your purchasing power over extended periods of time can be catastrophic. In 1960, a standard basket of goods which cost £1 today costs $40.52. That's an increase of almost 1926.0 per cent in 50 years, or a 95.10 percent decline in purchasing power, which is roughly the length of the average working life.

From this one piece of information, we can already draw two very important lessons. First, prices can't help but spiral upward over time. And second, the value of your investments has to rise more quickly than prices for you to get ahead in order to increase your purchasing power. And that's before we even think about paying the IRD and other nasty surprises. Let's look at an example.

Beating Inflation and the Tax Office
Say you put NZ$5000 into a cash management trust that pays you four percent interest each year. At the end of year one, your NZ$5000 has increased to NZ$5200 – just enough interest to buy a top-of-the-range pair of running shoes.

Say that prices are currently rising by about two percent each year, so we have to include this in working out how much your purchasing power has actually increased. It turns out that the real gain on your NZ$5000 capital, taking inflation into account, is not four percent, but two percent, or NZ$100. But don't rush out and spend it just yet.

Next, the IRD wants a cut. Income from interest-bearing investments in non-Portfolio Investment Entity vehicles is taxed just like your salary – at your marginal tax rate. And here's the real sting: you don't pay tax on your NZ$100 real gain, you pay it on your NZ$200 nominal gain, even though half of it disappears in higher prices. If your marginal tax rate is 30.0 percent, for instance, you'll pay NZ$60 in tax (30.0 percent of NZ$200), and make a NZ$40 real gain. At least you haven't lost ground, but if inflation had been any higher, or your return any lower, your purchasing power may well have fallen.

Clearly, the potential rate of return is only one of the variables you need to consider before making an investment. Cash deposits play a valuable role for most investors, and if, for instance, you need ready access to the cash, a deposit may well be a good choice. If, however, you're investing the money for a long period of time, it's almost certainly not the way to go.

For now, what's important is this simple principle: to increase your purchasing power over time, you need to earn a rate of return significantly higher than the rate of inflation. Sounds simple, doesn't it? But you may be surprised to learn that ignoring inflation is still one of the most common investment mistakes.

Shares offer the benefits of a higher prospective real return over time – although the risks over short time periods are higher, too – and far more favourable tax treatment than the more 'traditional' investments.