This content is for information and inspiration purposes only. It should not be taken as financial advice. To receive tailored, regulated financial advice into your own financial affairs and goals, please consult an independent financial adviser.
Inflation is generally understood to refer to the overall rise in prices, over time, within a given economy. If something (e.g. a dress) costs you £100 in 2019 and inflation rises by 2% twelve months later, then it would cost you £102.
In other words, the same amount of money (e.g. £100) gradually loses its “spending power” over time, with rising inflation. This is important when it comes to investing, as inflation can potentially eat away at the returns you are getting on your savings or investments.
Indeed, this quite often happens without many people realising. For instance, at the time of writing, Which? did some research to show that you would be lucky to get a bank account (unlimited-withdrawals) with a 1.5% interest rate. Yet UK inflation in June 2019 stood at 2%.
What that means is, you might commit, say, £1,000 to an account like this believing it would eventually grow to £1,015 by next year (i.e. 1.5% growth). In real terms, however, your £1,000 would be losing its spending power since inflation (2%) is 0.5% higher than your interest rate.
This isn’t to say that you shouldn’t have an instant-access savings account, with unlimited withdrawals. This can be a useful way to store emergency or short-term savings, for instance, which you might need to access quickly.
However, it does highlight the hidden eroding power of inflation on our savings and investments. In particular, if you want the money in your investment portfolio to grow over time, then you need to ensure that your investment strategy factors inflation into the picture.
After all, if you can regularly generate investment returns which beat inflation, then your money is not only going to grow on paper – but also in real terms. If inflation is 2%, for instance, and your investments grow by 8%, then your money has ‘real’ growth of an impressive 6%.
Investing to Beat Inflation
Of course, your primary goal when investing should be to beat inflation – but it’s typically an important “pillar” within your overall plan. If your main goal is to grow your wealth, then naturally, regularly beating inflation will be crucial. On the other hand, if your main goal is to preserve the wealth you have accumulated, then you will likely still want your money to at least hold its value as much as possible over time, and not be eroded by inflation.
The challenge is, it’s not possible to accurately predict what the level of future inflation is going to be. When you look back over recent UK history, there has been quite a lot of variation:
- 2% in June 2019
- 5% towards the end of 2011
- 2% at the beginning of 2008
- 2.96% in 2000
- 9.46% in 1990
- 17.99% in 1980 (largely due to a recession)
- 6.4% in 1970
It’s worth stating that the Bank of England was set up primarily to keep inflation low. So there is a strong reason to assume that we will not see inflation skyrocket to some of the figures seen above, any time soon. However, this is not guaranteed and certain events (e.g. a major change in the economy or government policy) could lead to a rise.
One of the main ways investors try to beat inflation with their investments is to incorporate some “Higher-Risk; Higher-Return” assets into their portfolio. These assets tend to pose a greater risk of generating a negative return on your original investment, but also possess the potential to generate a higher return which can beat the rate of inflation.
Investing in companies (either directly or via funds) is a good example of this approach. This is because many businesses (e.g. infrastructure and energy companies) can raise their prices in line with inflation to cover their costs. Theoretically, this can allow them to continue growing even as inflation rises.
This forms an important reason behind why even the most “defensive” or “conservative” investment portfolios (tailored to preserve wealth) often incorporate a degree of equities, rather than simply relying on fixed-interest assets such as bonds. This is because the interest you generate on a bond may not keep up with rising inflation, even though many bonds (i.e. “IOUs” issued by governments and companies) are generally seen as “lower risk” than equities.
Final Thoughts
There is no universally-agreed answer to the question of why inflation rises at different speeds over time. Yet it is generally accepted that a sound investment strategy should incorporate assets and tactics to mitigate inflation, and even attempt to beat it. It is very important to know the level of investment risk you feel comfortable with, but equally important to know as well is the level of investment return you need to meet your lifetime goals. People often overlook the risk of not reaching or having to compromise on their goals, because they avoided some level of investment risk.
If you are interested in discussing your own financial plan with us in light of the above discussion, then we’d be delighted to hear from you. Please get in touch to arrange a free, no-commitment financial consultation with a member of our team here at WMM.
