Savings & Inflation
The Impact of Inflation on Savings & Investments
How does inflation work?
In 1986 The average house price was £46,256 punts as it was then,
A HB Wibbly Wobbly Wonder was 25p
For £1 punt you could have bought
“TWO SHERBET FOUNTAINS, a Big Time, a ten penny bag and a Cornetto please.”
A Sparkle, a chomp, and two packets of Monster Munch instead of the Cornetto.
The purchasing power of money erodes over time. Long story short this is inflation
Impact on savings or investments
When thinking of saving or investing most people don’t account for inflation
A couple of the most common statements I hear when talking with clients about their savings or investment are
- I don’t want any risk or
- I am happy with my money on deposit, sure it is safe.
Having money on deposit is not as safe as you might think, when looking at it from a value of money point of view there is risk attached.
People don’t factor in inflation
The obvious impact of inflation on your savings is that the purchasing power is eroded. This means that if you stash €100 under the mattress today and inflation is 2% per year when you come back a year from now your €100 will buy 2% less stuff. Another way to look at it is, you would need €102 to buy the same amount of stuff a year later.
When you extend this to 10 years you might think that it would mean that you would need €120 to buy the same amount of goods but because of the effects of compounding you would actually need €121.90. Click here to calculate the effects of inflation on your investments. Don’t worry about the currency the math is the same.
As time goes by the impact of “only” 2% inflation compounds making it even worse. Einstein called compound interest the most powerful force on earth.
Unfortunately, compound inflation is just like compound interest working against you. When you look at the effects of 2% inflation on your savings over 25 years we find that prices will have increase by almost 65% and you will need €164.06 to buy the same basket of goods that €100 would buy 25 years earlier.
Inflation Causes Uncertainty
Because the value of your money is constantly changing, this makes planning for later life and retirement especially difficult since it is like shooting at a moving target. Especially, since you don’t even know for sure what the annual inflation rate will be.
Inflation- The Leaking Bucket
Over the long run since 1913 inflation has averaged more than 3% so on average it has taken less than 22 years for prices to double. So as you are saving it is like trying to fill a bucket while 3% is leaking out. So, therefore, you have to put it in faster than it leaks out.
What About Interest on Your Savings?
So far we have only looked at savings that were put under the mattress. What if you deposit them in the bank? Won’t that help? If the interest rate is equal to the inflation rate, then it would be like having a tap pouring water back into your bucket at exactly the rate it was leaking out.
Unfortunately, current bank interest rates are at historically low levels, so there is only a drip going into your bank bucket from interest and so the level in that bucket has been declining almost as fast as the money under the mattress.
Gold & Silver
Depending on what you invest in, some investments may do better or worse compared to inflation. Commodities like gold are often considered an inflation hedge and over extremely long periods gold and silver do retain their purchasing power. But often during the short-run distortions can occur and cause their value to become over or under-priced.
Seeing Gold an Inflation Hedge? Over the last 15 years’ inflation has been relatively low and gold and silver have outperformed the effects of inflation. But that may not always be the case. The major disadvantage of things like gold, silver, and other commonalities is that they do not provide a current income flow and so you are entirely dependent on their value increased to keep up with inflation.
Irish people love to be invested in property. Property is another commodity that has been thought to do well at keeping up with inflation which was true for many years until the market became overheated and property values plunged.
So like everything buying at the right price point is still important. Like gold, if you own your own home it is not producing income (although it may be saving you rent) but investment properties can provide some protection against inflation and income at the same time.
What about stocks?
Once again the price of companies should theoretically grow so that the company retains its value against inflation. But when you invest in stocks other variables are introduced including stock speculation (boom and bust), the ability of the company’s management to deal with change, changing market appetite for the company’s products, etc.
Quite often stocks & shares will outperform inflation allowing your investment to maintain its value against inflation but it is still possible that you will get in at the top and lose money over the short term or that any investment will underperform the overall market. Some shares pay dividends in addition to the possibility of share price growth. Share dividends would act much like the interest helping to fill your bucket, while theoretically, the share price itself should keep up with inflation.
One of the other factors that can affect the real return you experience after taking into consideration the effects of inflation is the effect of taxes. In the first scenario if you had put the money under the mattress taxes would have no effect. The €100 was after-tax income and because there was no additional income, taxes would not be a factor.
In the bank, scenario taxes would be minimal since interest rates are currently so small the money would have earned very little and so there wouldn’t be much tax due. But theoretically, if inflation was 2% and your bank account paid 2% interest, you would still be losing because you would owe taxes on your 2% interest. So with a 2% inflation rate, you may need to earn 3% interest just to break even.
Taxes on your interest can be thought of as diverting some of the flow that would have gone into the bucket away so it never makes it into the bucket.
The key to any good saving strategy is spreading your risk (hedging) through diversification. If your savings are made up of cash equivalents like deposit accounts, savings accounts, etc. these can be used for expenses that aren’t subject to much inflation i.e. you will spend them fairly soon.
If a portion of your savings are in commodities like gold, silver, and even real estate they will tend to keep up with inflation much better in the long run but will not produce any current income. These can be used for long term savings that you don’t plan on spending any time soon. Share values should keep up with inflation and may provide some income from dividends. Thus, because of the uncertainty of any form of investing it is a good idea to use a combination of these to protect against the unknown and the almost guaranteed erosion of purchasing power due to inflation.
You should not take a one fits all approach. Your circumstances are individual to you and so should your saving/investment strategy.
Always, always get professional independent advice. If you are dealing with one institution they will not tell you to go to another institution because they have a better option. An independent advisor can offer the best solutions no matter where it is. That is, of course, a solution is needed.
There are two different parts to consider when planning savings and a good independent advisor will help with this
Firstly, get to know.
What your time horizons are. Short, Medium & long?
What returns (interest rate) do you need from your savings?
How much risk you are willing to take to achieve the returns you need?
Only after the first part should you worry about the second.
Then and only then should you look for the solutions. Products and institutions are important now.
If you have any questions, please get in touch.
If you have saving or investments and want to examine the best strategy for you to give us a call, we are happy to help
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If you have any questions or need more information please give me a call.
The above if for information purposes only and does not constitute financial advice in any, we recommend that you speak with us before making any financial decisions. We recommend a holistic approach to financial planning and we can help you put your plans in place.