If you don’t plan effectively, inflation could cause your pot of hard-earned cash to shrink
Understanding inflation is an important factor when it comes to financial success. If you don’t factor inflation in when deciding where to put your money – whether that’s savings accounts or investing – you could find your pot shrinks over the years.
How does inflation work?
Inflation can go up and down, but if, for example, inflation was at 2%, this means the prices of key goods that households need to buy, such as food, fuel and clothing, would be rising at a rate of 2% a year.
So, in this scenario, if your savings weren't earning at least 2% a year, the effect of inflation would mean your money would buy less in a year’s time. For example, if you put £100 into a bank account paying 1% interest, you would have £101 after 12 months. But, 2% inflation means that the things that cost you £100 when you put your money in your account will cost you £102 a year later – so your money has lost purchasing power.
A long period of inflation means many household staples cost considerably more now than they did 10 years ago, meaning your money has to work a lot harder to buy the same things.
The cost of some foods, for example, has rocketed. A kilogram of minced beef would have cost you an average of £4.75 back in Autumn 2007, but a price increase of 57% over 10 years meant it cost £7.44 in October 2017.
The way to avoid this problem should be simple: place your money in savings accounts paying more interest than the inflation rate. But, unfortunately, accounts paying that level of interest are few and far between. Plus, if you pay tax on your savings interest, then you need an even higher rate of interest to leave your money growing faster than inflation.
So, what can you do?
The good news is that it is possible to get an inflation-beating return on your savings, as there are plenty of investment opportunities. But, this involves taking on a little more risk than a cash savings account.
Putting your money into a FTSE tracker could help you beat inflation, and another option might be to invest in bonds. Traditionally government bonds are seen as a very low-risk investment, but returns here have plummeted as people have raced to invest in these safe-haven investments.
Investing can be particularly helpful if you're wanting to save money for the long term. Inflation can really take a bite out of your returns over long periods, so you need to make sure your money grows faster than the prices of goods you'll want to buy with it. But with investing, you're taking on more risk than if you stuck with cash. The good news is there are many ways you can mitigate this, from choosing low-risk investments to spreading your cash across a number of asset classes and geographic regions.
Seeking impartial financial advice can help you to build a portfolio that aims to achieve the returns you want, while also reflecting your attitude to risk.
See how the price of common household goods changed from 2007 to 2017:
Chart shows price changes for common commodities from 2007 to 2017.
- A pint of milk: increase of 10%
- A loaf of bread: increase of 13%
- A litre of unleaded petrol: increase of 24%
- A pint of bitter: increase of 32%
- 250g of tea bags: increase of 33%
- 1kg of tomatoes: increase of 42%
- A nip of whiskey: increase of 50%
- 1kg of minced beef: increase of 57%
Source: Office for National Statistics
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