Inflation is the eroding and often hidden influence on your savings and investments which many people forget about. Consider the following scenario as an example:
- You invest £10,000 into your pension pot. For simplicity’s sake, let’s say this generates a 6% annual return over the next 30 years.
- By year 30, you could expect this £10,000 sum to grow to £57,434.91 through the power of compound interest.
- However, it’s important to remember that this £57,434.91 will not be worth the same in 30 years as it is today. This is due to the effects of inflation.
- Suppose (again, for simplicity) that inflation is 2% over the next 30 years. How would this affect your £10,000 investment?
- Inflation refers to the rate at which prices rise over time. So, if inflation rises at 2% each year, the £1 you hold in your hand loses 2% of its “buying power” each year.
- Taking the 6% annual return above, then, we can actually call this 4% annual growth (in terms of growth in “real-term buying power”).
- 4% compound interest on £10,000 over 30 years would be £32,433.98. In effect, you are getting £25,000.93 less than you thought you were!
Given how inflation can erode savings and investments in this way, it’s little wonder that clients regularly ask us how to combat it. After all, most people want their wealth to grow over time, and at the very least hold its value.
There is little that people can directly do to lower inflation to maximise the buying power of their savings and investments. Inflation control is primarily in the hands of the UK Government and the Bank of England, whose current remit is to keep inflation at about 2%.
This leaves savers and investors with two other primary options:
- Maximising their investment returns through appropriate portfolio construction.
- Reducing other costs which eat into your investment returns which you can control, such as investment management fees.
Let’s look at these two areas, briefly, to flesh out some ideas about how this might affect the investment decisions you take with your financial planner.
Maximise Investment Returns
For savers, do you remember the “good old days” of the late 90s when interest rates were between 5-7.25% (although perhaps not so fondly remembered by mortgage borrowers)? This meant that you could put your cash into a regular savings account, and reasonably expect your money to grow at a rate which beat inflation.
Take 1997 as an example. At this time, the Bank of England base rate was 7.25% whilst inflation stood at 3.14%. Assuming, then, that you put £10,000 into a savings account at 7.25% interest, after one year this could have produced £411 real-term growth after inflation.
Today, however, interest rates are at an historic low. In 2019, the Bank of England has set the base rate at 0.75%, whilst at the time of writing inflation currently sits at 1.5%. Given that banks often follow the base rate when setting their own rates, the cash in most UK regular savings accounts is actually losing value over time.
Given this situation, many people are looking to other options for growing the value of their money. This is where speaking to one of our financial planners about starting a coherent investment strategy can be a good idea.
For instance, investing into certain asset types (e.g. specific equity funds) could generate much higher returns than a regular savings account; perhaps as high as 5%, 8%, 10% or even more. However, the main downside you need to consider is the varying levels of investment risk which accompany these higher potential returns.
Working with an experienced financial planner, however, can help you to mitigate these risks in line with your investment goals and risk tolerance. For example, it might be that you construct a “portfolio” with your financial planner, which encompasses a range of equities (i.e. typically higher-risk; higher-return), bonds (lower-risk; lower-return) and other assets.
When you start investing, however, it’s important to recognise that different funds, products or companies might charge you for doing so. For instance, suppose you invest some of your money into a UK equity fund which is actively managed by a fund manager. That fund manager will often charge a fee to monitor and regularly “tweak” the investments in the fund, which is usually reflected as a percentage of your investment (e.g. 1%).
This is a great area where you can exert control over your investments, to mitigate the eroding power of inflation. 1% might not sound like a lot, but it can have a significant impact on returns over time.
Therefore, working with an experienced financial planner to find good investment prospects, with competitive fees, can translate into far stronger investment returns over the years and decades.
If you are interested in discussing your savings or investment strategy with one of our experienced independent financial planners, then please do get in touch, as we will be more than happy to discuss this in more detail with you.
This content is for information purposes only. It does not constitute investment advice or financial advice. To receive bespoke, regulated advice regarding your own financial affairs, please contact us.