We’ve spent a lot of time recently investing in the business. We’ve upgraded technology, adopted new software, even changed our branding to look more modern. Why? Because if we don’t move with the times, there’s a real chance we’ll be left behind. So, we’ve future-proofed our business to ensure that we can continue to do the best possible job.
This future proofing takes place in all aspects of our lives. Modern life has led to us constantly upgrading, moving forward and taking advantage of advances in technology. How many of us have moved from videos to DVDs to streaming services over the past 20 years? I used to have a cassette player that chewed up my favourite tapes, now I don’t even own a radio, just a small box in the corner that talks to me in a disjointed voice and plays anything I want to hear (and often things that I don’t). We upgrade different aspects of our home and work lives all the time, but are we ignoring our money?
How often do those of you over a certain age moan about the ever-increasing price of petrol or the simultaneous reduction in the size chocolate bars? It seems obvious to say that money doesn’t buy as much these days as it used to, but why is this? And what can we do about it?
The general increase in prices and the resulting fall in purchasing power of money is known as inflation. I could bore you with lots of statistics about the effect of inflation, but I’ll keep it simple and say that over the long-term, inflation can substantially reduce the value of cash. Prices now are 54% higher than they were 15 years ago; in other words, you would need £154 now to purchase goods that were worth £100 in 2004.
It’s true that the reduction in the value of money by inflation is unavoidable, but there are ways to reduce the impact on your savings. The most effective way is to move savings out of cash and into investment funds.
In my job I meet plenty of people who keep their life savings in cash because it’s ‘safe’. In other words, there’s no risk of their savings falling in value. However, cash isn’t as safe as it once was thanks to the current climate of ongoing low interest rates. Whenever the rate of inflation is higher than the interest earned on cash, the real value of the cash is eroded.
We recommend that our clients grow the capital value of their savings by investing in investment funds. The theory behind this is that over the long term, a diversified portfolio of investment funds will far outperform inflation and the returns available on cash. The chart below illustrates the superior returns from a medium risk portfolio when compared to cash interest and RPI since November 2004.
Of course, the counter argument for investing savings is that it’s a higher risk strategy than keeping everything in cash, so the losses are likely to be larger than the erosion of cash by inflation. This is true, but only to a certain extent. Falls in the stock markets are inevitable, but they’re also rarely catastrophic and in all cases throughout history, they’ve only been temporary. The chart shows that the falls in the value of the AFI Balanced index during the last stock market crash in 2008 were recovered within two years. The twelve months after November 2008 is the only period in the past 15 years when cash interest was higher than inflation.
If investing your savings isn’t an option because, for example, you’re saving for the short-term, there are still ways you can protect the value of your cash. Always make sure your cash is in a savings account paying the highest available rate of interest. Fixed-term accounts generally pay higher rates of interest than instant access accounts, but you should be wary of tying up your cash for the long-term and losing out on future interest rate increases. You should always make sure that you’re using the most suitable, tax-efficient method of saving.
You should also ensure that the interest on your savings is higher than the interest on your debts. It might sound obvious, but it’s amazing the amount of people who would rather keep large amounts of cash in a low-interest account ‘just in case’ rather than pay off a mortgage or credit card debt which charges interest at a far higher rate. We recommend an emergency cash fund of the equivalent of three months’ earnings
Continuing to do something a certain way because ‘that’s the way it’s always been done’ rarely stands up to scrutiny these days and that’s certainly true when it comes to cash savings. If you’ve moved on from winding damaged cassette tapes with a pencil and worrying about the consequences of the year 2000 on your VCR, you should also consider moving your money with the times.