Question:
I recently started regularly reading iafrica.com for the down-to-earth, easily digestible personal finance advice you find there. I've learned that one cannot hope to really beat inflation with money in the bank. I've also learned that shares are the best performing asset class.

What I would like to know is which asset class will in the long-term definitely beat inflation without the volatility of shares?

Answer:
With terms such as credit crunch, global financial crisis and recession still fresh in our minds, the financial spotlight has been focussed on two asset classes that sit on opposing ends of the risk and return spectrum. For equities, the long-term prospect of solid, inflation-beating performance is tainted by the short-term volatility. This may leave some investors a little nervous so they tend to look longingly at the 'safe' nature of cash. Of course, while many cash investors are comforted by the fact that they may never see a negative return, they too are becoming increasingly aware that inflation and tax are the proverbial trolls under the bridge, ready to gobble away at their purchasing power.

With that said, it does not need to be an all or nothing decision and one’s approach may take on one of the many successful permutations.

Firstly, what must be understood is that equities and cash are not the only asset classes in which one can invest. As far as traditional investing goes, there are two further asset classes that offer unique attributes of their own. These two asset classes, namely bonds and property, sit snugly between cash and equities on the risk and return spectrum, with bonds partnering closer to cash and property closer to equities. The general rule of thumb regarding the risk vs. return trade-off is that the higher the risk, the higher the potential return and vice versa. If we had to translate this to a ranking of these asset classes from lowest to highest risk (volatility), the order would be cash, bonds, property and equities.

The table on page two illustrates the 'behaviour' of these asset classes and allows a better understanding of what to expect from them over the long term. The figures (go to page two) are taken over a 20 year period (January 1989 to December 2008) and assume a maximum tax rate of 40 percent.

The figures in the table on page two confirm the previously mentioned 'thumb rule' of the risk vs. return trade off, with equities recording the highest and lowest returns in any given year (lowest being last year) as well as the most number of negative years over the 20-year period. This acceptance of risk (volatility), however, has been rewarded with the highest overall annual return of 16.1 percent, beating inflation by 7.4 percent on an annualised basis. If one had to role that concept forward, as the highest and lowest returns decrease along with the number of negative returns, so the overall average follows suit in a downward trend. Although these figures only take into account the past 20 years (property data doesn’t date much further back than that), if one had to take any rolling period of over 10 years dating right back to the 1900s, the trend will be much the same.

To respond to the question of which asset class will beat inflation without the volatility of shares, the figures in the above table suggest that property and bonds are the most likely to offer this type of return for an investor, albeit, without any guarantee.

Although this is an important question to ponder, perhaps the even more important question to ask is whether selecting a different asset class alone is the most intelligent way to go about mitigating the volatility inherent in equities while still achieving your required investment returns. With inflation-beating returns as the number one investment fundamental, one should move swiftly to investment fundamental number two: diversification.

Go to page two for the rest of this Q&A and the table illustrating the long-term behaviour of the various asset classes...

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