Saving or investing: Can they help beat inflation?

Investment returns need not rely on short term speculation

Anyone wishing to save for their future has an awkward task on their hands.

Thanks to the Bank of England's policy of ultra low interest rates, the annual interest available on current accounts and even savings accounts, from banks and building societies, is extraordinarily low.

The Bank's own statistics reveal some remarkable facts.

As of August 2012, instant access accounts offered a measly 0.22% interest, and deposit accounts just 1.51%.

Meanwhile cash ISAs offered an average of just 0.66% while fixed-rate savings bonds paid more, but only 2.49% a year.

The standout fact here is that most savings policies of whatever stripe offered less than inflation.

Which means that using most savings or deposit accounts at the moment guarantees that you will lose some of the real value of the cash you put in.

What can you do?

Using any spare cash to pay off debts, especially expensive ones such as credit cards, is one sensible alternative.

And if you can accumulate some savings it is always a good idea to have some cash at hand in an account anyway, just for a rainy day or an obvious big bill looming on your horizon.

After that though, especially if you want to put money away for a few years, then you could consider investing.

Given the news in the last few years, people could be forgiven for thinking that stock markets are casinos, useful only to people with a focus on short-term capital gains.

Many people also still think that cash on deposit still represents the safe and sensible choice for those more interested in long-term accumulation of capital or enjoying a steady income.

However, looking back over 50 years it is clear that neither of these is true.

Academic evidence shows that most stock markets have delivered returns well ahead of inflation over almost all periods of 10 years or more.

And the key factor has been the steady accumulation (and compounding) of the dividends which are paid to shareholding investors by most companies quoted on the stock market.

Value of dividends

The vitally important point here is that the multiplying effect of compound interest applies when reinvesting dividends.

And this represents by far the largest part of the real increase in value (ie after inflation) that stock markets can deliver.

For instance, over the space of 10 years, an average return of just over 7% a year from investing will double your original sum.

Given that it is entirely possible to achieve dividend returns of 3-4% a year from investing in shares, then very modest increases in share prices each year can top that up, and make that 7% target achievable.

Meanwhile, companies that produce a strong and reliable dividend stream have usually also delivered much better than average total returns (ie adding increase in share prices to their dividends.)

This does not mean that every company that pays no dividend is valueless (see US computer giant Apple, for example), but in general it is the steady dividend-payers such as GlaxoSmithKline, HSBC, Shell and Vodafone that do best.

Real businesses

So, stock market returns have usually done a better job than cash on deposit at preserving value against inflation.

This is not surprising if we think about what a share is: it is a slice of a real business that earns profits by providing customers with goods or services.

If inflation means increases in the price of goods and services, it follows that owning a slice of the profits will give some natural protection from inflation.

In contrast, holding cash on deposit, or owning bonds, amounts to having an IOU with predetermined terms from some government or company, and this approach is often more susceptible to having the value gradually eroded by inflation.

Of course, all investment necessarily involves risk of many sorts.

You might invest for 10 years, see your funds accumulate at an average of 7%, then be hit by a stock market slump just as you were seeking to crystallise your investments and turn them into cash.

This makes it important to consider which risks matter most to you.

Risks

If the key risk is the value of your investment falling by 10% or even 30% in a year, then cash on deposit is probably still a good choice and shares a bad choice.

By contrast, if the key risk you worry about is the post-inflation value of your savings falling by 50% over the next decade or two, or if you fear being unable to live on the meagre returns from even the best savings policies, then cash looks a bad choice and stock markets a better one.

Studying the past does not let us predict the future, but it provides a better guide than not studying it, and the academic evidence has more to tell us.

It suggests that:

• mixing different types of investment together can reduce, but never eliminate, most types of risk

• a steady dividend income is much more important and more reliable than sudden capital gains

• keeping down all investment costs is usually very important to long-term returns

• and that rapid trading (particularly if it amounts to 'buying high and selling low', as it often does) is one of the surest ways to increase the risk of disaster.

So, how does a sensible investor start investing in the stock market?

One way to do it is to invest in a selection of the hundreds of investment trusts and thousands of unit trusts available.

These include low cost index-tracking choices for those who do not think that they can pick a better-than-average investment manager.

Investment trusts are, in short, listed firms that invest in the shares of other companies; unit trusts are collective funds that allow investors to pool their money in a single fund.

Auto-enrolment

Obviously, no investment strategy is guaranteed to succeed.

But the rational case for investing your long-term savings will come to the fore for many millions of people in the next few years.

The government's landmark policy of auto-enrolment will see these people contributing to a pension for the first time, with contributions from their employers.

What they need to realise is that those funds will, in the vast majority of cases, be put into investment funds linked to the stock market and government or company bonds.

Knowing why that is being done with their hard-earned cash will help them understand if their money is being well invested or not, and will help them know what to expect.

The opinions expressed are those of the author and are not held by the BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Links to external sites are for information only and do not constitute endorsement. Always obtain independent professional advice for your own particular situation.