Last summer, Jane visited her friend Kate in the lovely Lake District. They took the ferry from Glenridding, walked back along the edge of Ullswater, then ate ice creams at a café near Pooley Bridge. It was a glorious day.
In December, Storm Desmond dropped more rainfall on the Lake District in two days than would usually fall in a month.
As you may remember, the floods created massive destruction. For example:
- Glenridding pier was underwater and the roads destroyed
- Pooley Bridge, which had stood for 251 years, was washed away
- Defences in Carlisle were built to withstand 7.2m of flooding, but the water rose to 7.9m, devastating homes and livelihoods
This was a dramatic event with major impact. Normally, erosion is caused by a drip-drip effect – however, it is so powerful it can create structures as huge as the Grand Canyon.
What about the money?
With relatively stable financial markets, there won’t be a sudden drop in your worth. But, whenever you keep cash on deposit, it gradually erodes due to inflation. The effect can be devastating on your purchasing power (and the purchasing power of your investments).
If you earn 2% interest, after a year you will have 2% more money. But if inflation is more than 2%, your money will purchase less than it would have to begin with.
- 1970: £1 = 10 loaves of bread
- 1980: £1 = 3 loaves of bread
- 1990: £1 = 2 loaves of bread
- 2000: £1 = 1.5 loaves of bread
- 2010: £1 = 1 loaf of bread
As shown in the graph below, if inflation sits at 3%, your £100 today will be worth the equivalent of just £25 in 40 years’ time.
Introducing the rule of seven
It is usually stated that the value of your investment is halved every seven years. Yes, I said halved. Reduced by half. A loss of 50%.
Inflation doesn’t have to be high to erode interest rates at their current low standing of only 0.5%.
Let’s assume you invest £100,000 today, with an expected return of 5%, and inflation at 3%.
After 25 years, your investment should be worth £338,635.
However, inflation will have cost you £176,901 in purchasing power, leaving you with an inflation-adjusted balance of £161,734.
This is a hypothetical example and assumes earnings are compounded annually. It excludes taxes, fees and expenses.
Tips for combating inflation
Some savings accounts are index-linked, which means they track inflation – but they don’t always keep up with other interest rates. Unfortunately, there is no sure way to beat inflation, but here are some tips:
- Own some investments with potential return that exceeds the inflation rate. Historically, stocks yield higher long-term returns than cash or bonds. However, there is also greater risk.
- Diversify your portfolio. Over the long term, a diversified portfolio typically outperforms one with a single asset class.
- Save more each year. Increase the amount you save each year by at least the inflation rate.
- Pay off any debts, especially those with high interest rates.
- Ensure your investment strategy takes inflation into account, especially if you’re living on a fixed income such as a pension.
- Invest some money for growth.
- Don’t keep your cash under the mattress.
Find the current inflation rate on the Bank of England homepage.
Of course, when you invest with Tucana, we take care of all the bullet points at the end of the article for you 🙂