Inflation: the silent destroyer of wealth
Recently I was on holiday in Devon, and I got a shock when my daughter went to buy ice creams: a 99 flake cost £3! I thought she’d gone mad – last time I checked they cost 99p, hence the name!
It got me thinking about the power of inflation.
I believe inflation is the silent killer everyone ignores when they’re looking at their finances. It’s like the sugar in our diets; a little is OK but over time a lot of it is a real killer.
Money on deposit – in bank accounts – earning less than inflation is in fact reducing in value. Inflation is the amount prices go up over time. Because it’s not in our face, it just happens, it’s often ignored. But that’s a mistake. Let’s look at why.
A 99 flake really should cost £3!
Let’s start by clarifying that I was not ripped off for my ice cream. The chart above shows that the price I was charged for my 99 flake was the right price – starting from 1987, when I was 13 years old and it is safe to a say a ‘99 expert’ with a cost of £1, RPI (Retail Price Index, one of two measures of inflation) shows that today that cost should be £2.89.
So despite my shock, the ice cream man was just keeping in line with inflation!
The erosion of inflation
If you keep your long-term savings in bank accounts, then put simply you’re losing out: it’s being slowly eroded by inflation.
This graph highlights the level of erosion:
The blue line represents inflation, RPI. The pink line represents a standard 90-day savings account. The red line represents the alternative way of measuring inflation, the Consumer Price Index, which doesn’t include housing costs in its calculations of inflation (which is why I prefer to use RPI, it’s a better measure of real-world living in my opinion).
Inflation has accumulatively risen 75% in those 20 years, while the savings account has returned just over 50% – and the difference has been getting wider in recent years.
Before the financial crash, we could safely get 5% in a savings account. But nowadays, you get a negative real return by holding cash on deposit.
The RPI for 2018 was 3.3%, which means a pound on 1 January 2019 is worth 3.3% less than it was on New Years Day 2018. There are similar figures for previous years too. Inflation is higher than the interest rate you’ll get, so your money is losing value.
That’s why your bank accounts should only be used to hold your emergency cash, committed expenditure in the next 3-5 years or money you’re going to need quickly. If you want your money to make money, then you have to invest it instead.
Investments beat inflation
Let’s examine that in more detail.
In this graph, the two inflation figures remain in red and blue, and are joined by the official Bank of England interest rate, the yellow line (this is different than the rate offered to you by banks, it’s just to give you more data). The fourth line in green shows the performance of the FTSE 100 stock market index.
The difference is huge: if you’d invested £1 in a FTSE 100 tracker fund in 1988, you’d have almost £14 today (ignoring the charges). If you were able to get the Bank of England deposit rate, you’d have £4.22.
You can see the volatility in the FTSE 100 performance, which covers the dotcom bubble in 2000 and the financial crash of 2007/08, the two big dips in the chart. After both, the markets recovered strongly (and continues to do so currently).
This is why I always say investing in the markets is about the long-term: at least five years, and preferably seven or more. If you need the money more quickly, the markets are too volatile and you could lose out if you’re investing at the wrong part of the cycle. When investing, time is your friend.
Diversification tops it all
Let’s look at one final chart that really highlights the differences between cash on deposit, cash invested, and inflation:
The data I have available only goes back to 1999, so that’s why I’ve started there.
Here you can see that the 90-day savings account (line D, in pink) is returning less than inflation; the FTSE 100 tracker fund (B, green) is comfortably ahead of both; but what’s beating everything hands down in terms of returns is line A in orange: a well-diversified global portfolio of index funds, which has returned over 226% on your money since 1999.
This perfectly highlights that investing your money for the long-term is the way to go (if you can accept the volatility), and that you should use deposit and savings accounts purely for emergency cash reserves and short-term expenditure of less than five years (if you’re planning to buy a car or make some home improvements for example).
It’s very easy to ignore inflation, but by being aware of the silent destroyer of wealth, you can make sure you’re ahead of its curve.