Introduction
Many people are happy to leave their savings in a bank account. This can give them instant access and guaranteed returns.
However, if the interest rate is below inflation, the spending power of their savings will fall over time. Taking this approach means they miss out on the opportunity to earn stronger returns that can beat inflation over periods of at least five or 10 years by investing in financial markets instead.
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The perils of inflation came back into stark relief in 2022. Between the Global Financial Crisis (GFC) and Covid, we had become accustomed to extremely low inflation.
Even low inflation, however, if left unchecked, will have a serious impact on your finances. If Einstein referred to compound interest as “the eighth wonder of the world”, then compounding inflation is not a challenge to be overlooked.
Ronald Regan famously referred to inflation “as violent as a mugger, as frightening as an armed robber and as deadly as a hit man”. Perhaps, but inflation is generally clandestine instead of overt: a pickpocket rather than a mugger. This is why it can be tempting to ignore, especially once it slips from the headlines.
Even the government’s target level of inflation (2%) will reduce the real value of a pound (i.e. how far your pound will stretch) by 18% over 10 years. Increasing either the time horizon over which inflation compounds or the level of inflation has a greater impact; 6% inflation over 10 years would roughly halve the spending power of a pound, for example.
The good news is that, over the long run, investments in asset classes such as equity and even fixed income should generate returns in excess of inflation. Equity markets have proven to be particularly adept at beating inflation over many decades. Cash, on the other hand, has a chequered history when it comes to beating inflation. It is, on the face of it, low risk. But once the impact of inflation is taken into account, it is not as low risk as it may first appear.
