14th September 2023
general
Even in normal times, inflation sits at around 2% - 3% per year. This means that over a decade, an average basket of goods and services could be one third more expensive than it was at the beginning. A sensible financial plan should build in some assumptions about inflation, regardless of the current status of the economy.
Below, we explain the 5 main reasons why a long-term investment plan is key in the battle against inflation.
You Probably Need More Than You Think
The first step of investment planning is to set some goals. These may be short, medium, or long-term. For many people, planning a comfortable retirement is one of the most important objectives. It is also likely to be your longest-term goal, and to take up a significant chunk of your financial resources.
When most people start planning their retirement, they are looking at least 20-30 years ahead. Since January 2000, the Consumer Price Index (CPI) has risen by around 80%. This means that someone spending £1,000 per month in retirement would need around £1,800 to provide the same lifestyle today.
Of course, there are a number of variables. Certain costs, such as mortgages, supporting children, and transport to work may no longer apply when you retire. Some items (and even individual brands) increase more than others, which means that you can control your spending to a degree.
But this doesn’t mean you should ignore inflation. Your spending may not increase every year, but building this into your plan means that you are better equipped to deal with economic turmoil or unexpected costs.
Generally, it’s a good idea to assume that your future spending will increase at least in line with average inflation every year, even if you think this is unlikely.
Cash Loses Value in Real Terms
Cash accounts are currently paying interest of around 4%, or potentially more if you are prepared to accept some restrictions. This is less than half the current rate of inflation. As interest rates are controlled by the Bank of England primarily to regulate inflation, it’s highly unlikely that your cash account will keep its value in real terms.
As an example, if you placed £10,000 in a cash account or money market fund 10 years ago, it would probably have grown by less than 6%, leaving you with around £10,600 today. On the other hand, inflation has risen by nearly 35%, meaning that you are actually 29% worse off in terms of purchasing power.
We have seen very low interest rates through most of this period, as well as extremely high inflation latterly. During the previous 10 years (from 2003 – 2013, which, despite the financial crisis, saw relatively normal rates of interest and inflation) the gap was closer to 12%.
If you keep money in cash over the long-term, the real value of your pot is likely to erode significantly.
Equities Provide the Best Chance of Beating Inflation
Investing in the stockmarket has consistently proved to be the best way of beating inflation. The Global sector (comprising funds which invest in companies across the world) has grown by around 132% over the last 10 years, almost 100% ahead of inflation.
The UK All Companies sector has risen by around 60%, so while the returns are not as high as a global portfolio, they are still well ahead of inflation.
Of course, investing in equities carries some risk, as the values fluctuate daily. Some investors lose money, although this is usually down to user error, for example, taking money out during a downturn, not giving their investments enough time, or having too much exposure to one area. A diversified portfolio of equities, held for the long-term, offers the best chance of beating inflation.
A fully equity-based portfolio may not be suitable for all investors. Mixing in bonds, property, and some cash holdings can help to reduce volatility and increase diversification. Interestingly, the Mixed Investment 40% - 85% sector (which broadly represents a medium to high risk level) has returned almost the same amount as the UK All Companies sector over 10 years. This suggests that wider diversification has added more value than simply holding UK equities.
Growth is Compounded
On average, the Global sector has produced returns of 8.8% per year. Over 10 years, this amounts to 88% in simple terms, or £88,000 on a £100,000 investment.
However, if you remained invested throughout, your actual return would be 132%, or £132,000. This is because growth is compounded. Not only do you receive growth on your initial capital, but also on the returns you achieve each year. This can boost growth exponentially. Additionally, if you reinvest any dividends, compounding is enhanced further.
To really benefit from compounding, and the additional inflation protection this offers, you need to invest for the long-term.
Short-Term Thinking Can Damage Returns
One of the main reasons why some people are unsuccessful with investing is because they are focused on the short term. This can lead to:
There is no easy answer or quick fix when it comes to investing. You simply need to invest in a diverse range of assets and keep your discipline over the long-term. If you stick to the plan, you have a strong chance of beating inflation and achieving your investment goals.
Please don’t hesitate to contact a member of the team to find out more about investment planning.
All performance/index figures taken from www.trustnet.com
