Most of us vividly remember the outrage when Toblerone decided to shrink its chocolate bars. As consumers, we felt totally ripped off. But it’s not just chocolate. From your daily coffee to the price of a train ticket, it just feels like your money doesn’t go as far as it used to, doesn’t it? This, my friend, is the power of inflation.
Inflation is the reason penny sweets no longer actually cost a penny and a 99 Flake ice-cream could cost you as much as £3 nowadays, depending on where you are in the country. So, £100 today is unlikely to buy you as much in a decade. For example, in 10 years’ time your £100 could be worth just £82 with inflation at 2% a year, which is considered the norm.
But despite how it might feel, prices going up isn’t actually a bad thing. In fact, things need to get more expensive every year for the economy to stay healthy and grow. What it does mean, though, is that keeping all your hard-earned cash under the mattress for 10 years is decidedly not a good idea.
No problem – my savings are safe in a bank account!
Well, define safe. Sure, it’s unlikely that someone will steal them. And even if someone would, your bank will probably reimburse you (unless you have done something silly such as share your PIN or password…). But just because your savings remain the same, it doesn’t mean they are worth the same. This is where the relationship between inflation and interest rates comes in.
Now, you’ve probably heard that inflation in the UK has plummeted recently. In May, it fell to just 0.5%. This, of course, does mean that your £100 loses its worth at a slower rate than the standard 2%. But before you rejoice, we have some bad news. Unfortunately, lower inflation inevitably leads to low interest rates. And in the worst-case scenario, the interest rate on your bank account can be lower than inflation, which basically means that inflation is eating away at the future value of your savings. Bon appétit! Ehm, I think not.
So why is this ok, you might ask? Simply put, interest rates are a tool used by central banks to make people spend more or less money, depending on the economic situation. To get people to spend more, the central bank cuts interest rates – this makes it cheaper for people and companies to borrow money so they can spend it. And since things are pretty dire right now, interest rates are at rock bottom at around 0.1%, which is the lowest level in…well, actually, EVER. If this seems like practically nothing, that’s because it is.
What does this mean for you? Well, if you’re planning to borrow money, you’re in luck! But if you want to save? Not so much. With interest rates so low, you might as well put it under that mattress we talked about earlier as a bank account won’t be much better. In fact, the only advantage over a mattress is that your savings in a UK-authorised bank are protected by the Financial Services Compensation Scheme (FSCS), up to £85,000 per bank. So while you may not be making money, at least you are not at risk of losing all of it.
Unfortunately, this isn’t actually anything new. Interest rates have been mega-low for a long time and keeping your savings in cash hasn’t been a good idea for decades. Really? Well, according to data from the Bank of England and FE fundinfo, if you had put £10,000 into an average Cash ISA 10 years ago it would be worth £9,579 at the end of March 2020 in real terms (nom, nom, nom). However, had you invested it you are likely to have done much better.
But what about the risk of a stock market crash?
Well, lucky for you we have a recent example! Due to COVID-19, stock markets around the world were in free-fall earlier this year and March marked the bottom of the crash with markets falling 30%-40% (depending on the market) in the space of just one month. So surely you would have been even worse off had you invested it?
Well, the thing with investing is that time and compounding are your friends and can compensate for big falls in markets. So, if instead of putting that £10,000 in a Cash ISA, if you had invested it in, for example, the Vanguard World ETF (one of the largest and most liquid passive funds in the market) it would have been worth £17,853 at the end of March. And to make matters worse (from an opportunity cost perspective), if you were lucky enough to have put it in some of the best performing active funds out there (hindsight is a beautiful thing, we know), then it could have been worth at least £26,237 (based on the median return of the top decile of OEICs, source FE Analytics) at the end of March this year. In case it wasn’t clear, both of these figures are after
the COVID-19 stock market crash has been taken into account.
Now, the purpose of this exercise is not to make you cry into your coffee, but to highlight the perceived sense of security a savings account can offer for long-term savings. It basically comes down to timeframes. Savings accounts are great for storing money you may need immediate access to without warning (like a large dentist bill, a new laptop after spilling a glass of wine all over it, you know what I mean) or for any large purchases you plan in the next five years. But for anything further out than that, you should seriously consider investing it because unfortunately, low interest rates are here to stay, but your purchasing power won’t.
Date of publication: 10th July 2020
The information in this post is not financial advice, it is provided solely to help you make your own investment decisions. If you are unsure about whether an investment is appropriate for you, please seek professional financial advice. You can find more information here.
When you invest you should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future return.