Let’s say you have £10,000. There’s no rule that says you have to invest it.
In fact, many people would spend it!
Why not put it under the mattress, and leave it for a rainy day?
One word: Inflation.
Take a look at this graph:
This graph shows how what you can buy with £10,000 falls over the years, due to the impact of inflation.
Inflation is the tendency for the cost of things – bread, houses, wages – to rise.
As such it reduces the spending power of your money each year.
- In 25 years time, you will still have £10,000 in nominal terms. Your twenty £500 notes will still be under your mattress, and the Queen of England will still be frowning at you.
- But in real terms the spending power of your money will be diminished.
The graph shows the impact of just 2% annual inflation on your money.
2% reduces the value of your money by only a little bit each year, but it adds up to a 40% loss in real terms over 25 years.
The inflation rate can rise and fall
The Bank of England and many other countries target a 2% inflation rate.
But sometimes, such as in the 1970s, inflation can rise to 5-10%. Such a high inflation rate can halve the value of your money in less than a decade.
Inflation can get even worse in extreme situations, such as 1920s Germany or Zimbabwe more recently. Hyper inflation in a crisis can hit triple digits or more.
Lesson: The first reason we invest is to maintain the spending power of our money. Every year we need to grow our savings by at least the rate of inflation.
Generally – but not always – you can keep up with the rate of inflation by keeping your money in a good cash savings account.
Even today, you can find cash deposit accounts paying 2-3% on your savings.1
Cash accounts pay interest on your total savings. By adding this interest to your existing pile of money, you can grow your savings over time.
This may seem trivially obvious, but it’s an important point.
The spending power of each £1 still goes down over time. But by growing the total amount of £1s in your savings pot by earning interest and reinvesting it, you can aim to offset the impact of inflation and maintain the spending power of your total savings.
- The real value of £1 decreases over time, due to inflation.
- Over the long-term, this can seriously reduce your wealth.
- At the least, we need to invest to offset the rate of inflation.
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- Note that after taking tax on interest into account, however, most people’s after-inflation return will likely be negative at these low rates.