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:
[1]
This graph shows how what you can buy with £10,000 falls over the years, due to the impact of inflation [2].
Inflation is the tendency for the cost of things – bread, houses, wages – to rise.
As such it reduces the spending power [3] 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 [4] or Zimbabwe more recently. Hyper inflation in a crisis can hit triple digits or more.
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, and especially not in recent years – you can keep up with the rate of inflation by keeping your money in a good cash savings [5] account.
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 [6], you can aim to offset the impact of inflation and maintain the spending power of your total savings.
[7]The red bars show the impact of 2% inflation. The blue show the effect of a 2% interest rate.
In the graph above:
- The blue line shows how your £10,000 grows over 25 years with 2% interest. This is the amount you see piling up in your bank account.
- The red line shows how £10,000 would lose its value in real terms at 0% interest. For example, if kept under your mattress!
In reality you will get interest and see your wealth rise but – invisibly – each pound in your bank account will also lose some of its spending power due to the impact of inflation at the same time.
If inflation was running at 2% for the entire 25 years and interest rates were also 2%, then the two would cancel each other out.
This is shown in the green bar in the following graph, which is the real spending power of your money, with 2% interest and 2% inflation.
[8]
You’d very rarely see inflation and the interest rate on your cash savings exactly matched like this, of course, let alone for 25 years!1 [9]
Some times interest rates will easily outpace inflation. At other times it will be very hard to get a real return, especially if you pay tax [10] on your savings.
But the principle is clear. At the very least, you need to grow your money in nominal terms, just to offset the corrosion of inflation.
Investing like this will at least maintain the spending power of your money.
Key takeaways
- 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 [11].
This updated post is from our occasional series [12] on investing for beginners. Subscribe [13] to get our articles emailed to you (we publish three times a week) and you’ll never miss a lesson! And why not tell a friend [14] to help them get started?
- Some interesting products such as the government’s sadly suspended index-linked savings certificates did enable this, plus a bit of icing on top. [↩ [18]]