Updated 03 December 2020
Years ago we had the credit crunch â will the savings crunch be next? A double-whammy of low interest rates coupled with inflation could cause your âsafeâ cash savings to erode. Maybe itâs time to look at some alternative strategies.
You know the traditional hierarchy of investments? (Actually, no. I have a life. Ed.) Well, all right â itâs actually much simpler than it sounds. All that means is, there are different ways in which you can put money aside, when you want to save it and (hopefully) make it grow. Some can make your money grow faster, but will bring more risk of losing money. Others tend to bring slower growth, but will (usually) ensure that you wonât end up with less than you started with.
Things like stocks & shares fall into the bracket of âhigher riskâ investments. Â At the other end of the scale we have âlow riskâ assets such as government bonds and (of course) cash.
Cash savings are traditionally considered among the safest assets, if not the safest. You put Â£100 in a savings account and it earns interest â or at the very least, it continues to be worth Â£100.
Unfortunately, there are times when that doesnât happen. Cash savings are subject to two opposing forces: interest on the one side, and inflation on the other. And while interest increases the number of pounds in your bank account, inflation decreases the buying power of each of those pounds. The challenge for you as a saver is to make sure the first of these horses stays ahead of the second: you want interest to outpace inflation, not the other way around.
Unfortunately, this race just hotted up.
Interest versus inflation
Savers have had a difficult few years. Interest rates have been very low ever since the 2008 financial crisis, falling even lower from 2012, and the turmoil surrounding the Brexit vote caused yet another cut â just when an increase seemed to be on the cards. This made saving frustrating, but with inflation also very low it was still possible to earn small returns over time.
However, in the wake of the Brexit vote, inflation has begun to rise again. As the graph shows, savings interest on the best-value easy access accounts has managed to stay ahead of inflation since around August 2014. But the signs are that the lines will soon cross again, bringing inflation higher than the best savings interest.
When the blue line (inflation) once again rises higher than the orange one (interest), anyone withÂ cash savings will start to lose money in real terms. The loss may not be much, but over time it will be noticeable â and the higher inflation rises above interest rates, the faster the loss will be.
When is low-risk saving risky?
Investing is about risks versus returns: the risk of losing money, weighed against the chance of earning more. Every investor from Warren Buffett downwards must tackle this balancing act. But many savers dislike the idea of any risk at all, preferring to stick exclusively to cash savings. What they may not realise is that in a high-inflation, low-interest economy, cash savings are not zero risk. On the contrary: in that environment, they are virtually guaranteed to lose you money.
Of course, a cash savings account with Â£1,000 in it will never show less than Â£1,000 if you take no money out, even in a zero-interest economy (but see the caveat belowâ¦). However, inflation at 1 per cent will reduce its buying power to Â£990 in the course of single year. Thatâs not a huge loss, but no-one wants to discover that their carefully saved money is actually shrinking. For instance, as recently as 2011 inflation was over 5 per cent. If you were to have Â£10,000 of savings at 1 per cent interest, then 5 per cent inflation would cost you around Â£400 of buying power over the year.
Now for the caveat. We said that an account with Â£1,000 in it would never show less than Â£1,000. However, this can happen in a climate of negative interest rates. If rates go so low as to be negative (as they did in Japan) then it will actually cost you money to keep savings in a bank. There are no signs yet of this happening in the UK â but weâve had surprises before.
How to reduce risk â by taking on more
In a low-interest, high-inflation economy, the risk involved in cash savings will rise. You might not lose large sums, but some loss may be inevitable. In this situation, even the most cautious saver may want to start exploring alternative ways to save and invest. This is particularly true at times when the stock markets appear to be doing so much better than savings accounts.
But that doesnât mean throwing caution to the winds and swapping all your cash for a bunch of shares. The secret of successful investing is to understand the nature of risk â and specifically, what âriskâ means for you personally.
For example, if you are saving for a time in the future (such as a child going to university in five yearsâ time) then a loss of a few hundred pounds in one particular year may not hinder your overall plan, so long as overall growth over the five years is positive. However, steady annual losses (or static savings) over that period is precisely what you donât want. In this situation, it may make more sense to choose investments that can offer higher returns, even if they may also deliver short-term losses.
Another important aspect of investment is knowing how to divide up your assets. This is the âlots of eggs, lots of basketsâ rule. Work out how much money you need for daily living and emergencies, then see how much is left over. Some of this you may still want to keep in low-growth, easy-access accounts, but with the rest you can afford to be more adventurous. This is the portion of your assets that has the potential to earn you long-term returns.
Find out if investment is for you
So how do you work out the right amount of risk to take? The easiest way is to talk to an independent financial adviser. With most advisers, one of the first things they will do with you is a risk assessment, to find out your ideal investment strategy. Many who consider themselves cautious people discover they can take far more risk; conversely, those with a more cavalier attitude may discover that they need to rein themselves in. By working out your own ârisk toleranceâ, you can venture into higher-risk investments without it posing a serious risk to your plans. In fact, taking on some risk may prove to be less risky â in the long term â than playing âsafeâ with cash.
Talk to your financial adviser about how to get started in investing. You can find one easily from our home page.