It’s easy to think of inflation as something that only economists need to worry about. In fact, we should all be keeping an eye on inflation and its effect on our money.
Inflation isn’t a bill that you pay directly, but it can cost you dearly over the long run. Without careful financial planning, you run the risk of your money’s purchasing power being eroded over time.
Taking some really good financial advice could help you avoid this so-called ‘hidden tax’ but, in the meantime, read on to find out how inflation really works and what it means for you.
What is inflation?
Inflation refers to the way that prices for goods and services increase over time.
An easy way to measure inflation is to compare the cost of things today with how much they cost in the past. So, if inflation is 2%, it means prices are, on average, 2% higher than they were a year ago. If a loaf of bread cost £1 a year ago and it now costs £1.02, its price has risen by 2%. That doesn’t sound like much, but it adds up over time.
The effect of inflation is more pronounced over longer periods of time. According to the Bank of England’s inflation calculator, goods and services costing £10 in 1980 would cost £43.85 today. This is because inflation averaged 3.8% over the last 40 years.1
How does inflation affect me?
Higher food and fuel bills are the most noticeable effects of inflation. If your salary hasn’t kept up with inflation, you might find your household finances are squeezed.
A less obvious effect of inflation is the way it erodes the value of your savings. Let’s imagine you have £100 sitting in a zero-interest bank account. Over time, inflation will reduce the ‘real’ value of your £100. After 25 years, you’ll still have £100, but you’ll be able to buy significantly less with it than you could at the start.
The chart below demonstrates how inflation can reduce the value of £100 of cash savings:
Source: Brewin Dolphin. Impact of four hypothetical rates of inflation on £100 of cash over 25 years. For illustrative purposes only.
If you’re saving for a long-term goal, like retirement, then it’s really important to factor in inflation. You might think saving up £600,000 will set you up for a comfortable retirement but, in 20 years’ time, that £600,000 probably won’t go as far as it does now.
How do I protect myself from inflation?
To prevent inflation from eroding your savings, you need to ensure your money grows at or above the inflation rate. The rate of inflation changes from year to year, and even month to month. Ten years ago, the rate was above 5%. So even if inflation is low, you can’t assume it will stay that way forever.
Over the last 40 years, inflation has averaged 3.8%, which means that unless your money has grown by at least 3.8% each year, its real value will have fallen.
Interest rates on cash are typically below inflation and currently very low. The highest rate on an easy access savings account is around 0.6%, while the highest rate on a five-year fixed-rate savings account is 1.8%.2
If you keep all your money in cash, there is a high chance it will lose value over time, which could put your financial plans in jeopardy.
Is it possible to beat inflation?
Investing in the stock market gives your money the opportunity to beat inflation and grow in value. Equities carry investment risk, but history demonstrates that, over the long term, they tend to outperform cash and produce an above-inflation return.
The important thing to remember is that equities go up and down in value. This means you should invest for the long-term – at least five years – and spread your money across different asset classes, sectors and regions. By diversifying your money, you can reduce the impact of one asset or sector falling in value.
Taking control of your finances can feel daunting and, let’s face it, not hugely interesting. But the impact it can have on your long-term financial wellbeing makes it well worth doing, and it’s not something you want to get wrong. Taking some really good financial advice could make a real difference to you and your plans for the future. So why not speak to one of our financial advisers today?
2 https://www.moneysavingexpert.com/savings/savings-accounts-best-interest/ Data retrieved 31 August 2021
The value of investments, and any income from them, can fall and you may get back less than you invested. Neither simulated nor actual past performance are reliable indicators of future performance. Investment values may increase or decrease as a result of currency fluctuations.
Information is provided only as an example and is not a recommendation to pursue a particular strategy. Information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness.
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