With current interest rates on cash savings very low, it is difficult to achieve growth above the rate of inflation. And if the cost of living is rising faster than your savings are growing, you’re effectively losing money. Our Chartered Financial Planner, James Cannard, has been having a lot of conversations recently around deposit based savings and a reoccurring question that pops up is “is my money working hard enough for me?”. For those who are predominantly holding cash for long term savings then the answer, on the whole, is “no, it isn’t”.
With cash savings, a penny saved is a penny earned. But thanks to inflation, over time, the value of the penny saved could be much less than when it was earned. When looking at investments, always focus on what is the real return or the return net of inflation.
Over longer periods, well-managed investments usually grow by more than cash. Even if inflation isn’t a worry right now, you should still factor it into your investing strategy.
We have recently reviewed Mr & Mrs H who have historically kept a large contingency fund in cash and other deposit based savings in addition to some existing investments. A growing concern for them is that the possible risk of post-Covid inflation, coupled with historic low levels of interest being received, will result in their savings losing its purchasing power over the long term which is the majority of their wealth.
To help mitigate this it was decided to utilise some of the surplus cash savings and invest for growth within a broad range of assets in line with a risk profile they felt comfortable with. For them they felt the risks of being exposed to low interest rates and inflation outweighed those of investment.
Below we explain in simple terms how to beat inflation.
Consistently outpaced inflation
Investments that change in value a lot day-to-day tend to increase in value the most over several years. Investments that change in value a little day-to-day tend to increase by less over several years.
So, if it doesn’t worry you to see falls in value occasionally, and you have enough money in other places that it wouldn’t affect your lifestyle, you might target high growth with higher risk investments, for example, a portfolio of equities. Investing in equities over a long period has consistently outpaced inflation.
Lower risk investments
Otherwise, you might target just enough growth to beat inflation with lower risk investments. One example is bonds: loans given to governments and companies that are repaid at a fixed rate of interest.
Either way, there is always the risk that you could lose money, so you should keep enough savings separately in a cash account to cover any emergency expenses and short-term savings goals.
Ahead of inflation
One good way of staying ahead of inflation is buying stocks that pay good dividends. Dividends are a tangible return paid by companies and can keep up with inflation. And just like inflation, dividends, too, can be calculated annually.
This figure, called the dividend yield, can be measured by adding dividends received during the year and dividing it by the stock price. The yield must be higher than the annual inflation rate. Asset allocation is also critical. In this, one can look at an opportunity to diversify globally. This will make your portfolio more stable and less vulnerable to domestic volatility and inflation.
Because investments have potentially higher returns than cash savings, it’s important to protect your returns from tax. Two common ways to do this are through Individual Savings Accounts (ISAs) and pensions.
ISAs currently allow you to invest up to £20,000 a year (tax year 2020/21), which can provide a tax-efficient return through interest, capital gains and dividend income. Pensions offer the same benefits, plus tax relief on your contributions up to a maximum of £40,000 a year (or 100% of your salary if it is less than £40,000). However, you can’t currently access your pension money until you reach age 55.
INFORMATION IS BASED ON OUR CURRENT UNDERSTANDING OF TAXATION LEGISLATION AND REGULATIONS. ANY LEVELS AND BASES OF, AND RELIEFS FROM, TAXATION ARE SUBJECT TO CHANGE.
THE VALUE OF INVESTMENTS AND INCOME FROM THEM MAY GO DOWN. YOU MAY NOT GET BACK THE ORIGINAL AMOUNT INVESTED.
PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE PERFORMANCE.