Impact of rising prices on investments
A POUND saved is a pound earned. But thanks to inflation, over time, the value of the pound saved could be much less than when it was earned. One cannot ignore the corrosive impact of rising prices on investments.
Investors can easily fail to prepare for the risk of inflation eroding the purchasing power of money, especially in a low-inflation environment. Thus it is wise for portfolios to include assets that provide some protection against unexpected inflation.
After two years when consumer prices in the UK barely rose, there are signs that inflation may be about to return. If it does, how should you prepare? To protect your purchasing power over time, your savings need to grow at least as quickly as prices are rising.
The Bank of England forecasts that consumer price inflation will remain above two per cent in each year until 2021.
While nowhere close to historic highs, higher inflation stands in contrast to near record low interest rates offered on cash savings. Higher inflation represents a hike in the cost of everyday living and the higher it rises, the less your cash will be ultimately worth. Rising inflation weighs on both real wages and savings returns for UK consumers.
Keeping enough cash aside to cover any foreseeable costs you might face is always sensible, typically three to six months of your monthly outgoings.
However, relying solely or overly on cash might prevent you from achieving your long-term financial goals, which may only be possible if you accept some level of investment risk.
Worse, in an environment where the cost of living is rising faster than the interest rates on cash, there is a danger that your savings will slowly become worth less and less, leaving you worse off down the road.
If you are prepared to take on some investment risk, you could look at investing in a bond fund to look for higher returns. Bond funds invest in a basket of IOUS issued by governments and/ or companies looking to raise cash. When someone invests in a bond, they are essentially lending the bond issuer their money for a fixed period of time.
But higher inflation can also be bad news for investors in bonds. Bondholders receive regular income payments, known as ‘coupons,’ from the government or company that issued the bond.
Broadly speaking, bonds are typically viewed as a lower-risk option than shares and generally offer a relatively steady and predictable income, though some bonds do carry higher risk than some shares.
Opting for a bond fund can help you diversify your risk but these portfolios come in many guises and some will carry greater investment risk than others. Generally they will all hold bonds that are at various stages of their life and therefore will vary in value.