Interest rates and inflation, both terms we are familiar with, whilst not always appreciating how closely the two are connected, or that both affect our immediate and longer term financial security.
When we hear about interest rates, we might think of the bank. This is correct, but let’s clearly define what the term interest rate means. For savers (as opposed to borrowers) an interest rate can be seen as a percentage-based payment which the bank (or indeed any other savings institution) pays us for holding our cash. This means that when we put our money in a bank account, the bank compensates us financially for having placed our funds with the bank. Simple, right? Inflation can be a slightly more difficult concept to understand, but it is something we experience daily. Inflation refers to the general increase in prices of goods and services over time. This happens for a number of reasons, which won’t be examined here. The important point to understand is that inflation, whether gradual or accelerating, means prices are going up.
How then are interest rates and inflation linked? Well, the connection is quite straightforward. As mentioned, the bank is paying its savings customers an interest rate, so let’s consider the actual value of that interest rate. Most likely the rate you have been receiving over recent years has been no higher than 0.5% per annum. But inflation has been averaging around 2% per annum and has increased substantially over the past year or so. What does this mean? Assuming interest at 0.5% and inflation at 2%, the money in your bank account is losing 1.5% of its value every year (2% – 0.5% = 1.5%). This means that by keeping funds idle in a bank account you are actually destroying the real value of your money. The longer the cash is left there, the more value it loses.
Now that you’ve read the above, you may be asking yourself if there is a way to avoid destroying the real value of your money. That is where companies such as Spectrum can help. After reviewing your circumstances and going through a risk profiling exercise, your Spectrum adviser can help you build a suitable portfolio of diversified assets with the aim of getting your money working harder. A typical ‘balanced-risk’ portfolio, for example, has achieved annualised returns of 4% to 6% over the medium to long term. Of course past performance is no guarantee of future returns but with sensible planning it is entirely possible to overcome the negative effects of inflation – indeed, investment success and achieving positive real returns generally rely on such planning.
The above article was kindly provided by Jozef Spiteri from The Spectrum IFA Group and originally posted at: https://www.spectrum-ifa.com/interest-rates-and-inflation/