If we don’t have our money invested at a rate that beats inflation then we are losing money. True, in specific sterling or dollar terms. If inflation is running at 5% and we invest at 3% then it is clear that next year our money will buy us 2% less than it would buy us this year. But that isn’t the whole picture.
For starters, headline inflation is only an average. It is a mean of all the various different price fluctuations across all consumer goods and services. Some things could be increasing in price and some could be going down. And depending upon what you spend your money on dictates to what degree the true value of your money changes. For example, if high fuel prices are driving inflation upwards but you have an off-grid house and don’t drive a vehicle then the fuel price inflation doesn’t affect you to the same degree as others. It may have a smaller effect on, for example, the costs of other items that you purchase but to a much lesser degree than someone who spends a significant portion of their money on fuel related items.
The other thing to consider when deciding how to invest, particularly when there are inflationary issues, is timing.
Often people with savings will seek to tie up their cash in longer term accounts offering better rates in an attempt to reduce the effect of inflation erosion on the value of their money. That’s all well and good until you consider the possible opportunity cost of tying money up for long periods of time. It may be that while the money is locked away there are opportunities which are unable to be taken but which could have yielded higher returns. Sometimes it is better to take a lower rate of return in exchange for the ability to immediately access savings when opportunities present themselves.
And opportunities can take a variety of forms. They could be different investments, alternate accounts, or opportunities to make changes that bring savings. Take, for example, reducing high interest debt. Rather than save, if you have high interest debt then you could beat inflation by paying it off rather than investing in interest bearing accounts. If you have debt at 9% per annum, savings at 3% per annum and inflation running at 6% then you can actually BEAT inflation by using surplus cash or savings to pay down the debt. And you’d be surprised how many people carry debt and retain investments. I have a £100,000 mortgage at 2.7%. That rate is fixed for another three years. I have over £100,000 in various accounts earning an average of between 3 and 4%. It makes no sense to pay off the mortgage now. If the fixed rate came to an end today the variable rate would rise to 8%, and the best new fixed rate mortgage I could get would be 5%. In that scenario I would immediately withdraw £100,000 from my savings and pay off that mortgage. It makes perfect sense to borrow money at 2.7% and earn 4% on savings. But it makes no sense at all to service debt at 8% and earn 4% on the same amount in savings.
Things like credit card debt are even worse. Rates of 20-30% are not uncommon. Don’t hold savings while you have debt like that. You are just going backwards. Fast!
Inflation can erode the value of your money. Debt will usually erode it faster than any inflation. When considering how best to invest, invest to beat debt first, then try to beat inflation.