High inflation can be a nightmare for investors and savers, especially when interest rates are low, just as they are today. Indeed, savers face a triple threat of stagnant wages, rising inflation, and interest rates that are only marginally above their all-time low.
This combination of negative factors means that savers are seeing a negative inflation-adjusted return on their money. The real interest rate — the Bank of England’s base rate minus the rate of inflation — is currently -2.5% meaning that your savings are losing 2.5% of purchasing power every year.
In this environment, stashing your cash away in an ISA is downright dangerous. The best interest rate offered for a cash ISA at the moment is 2.15% from Virgin Money, but you have to be prepared to lock your money away for five years. If you lock your money away at this rate, and inflation continues to track at 3% per annum, at the end of the five-year period the purchasing power of the initial £5,000 will have declined to £4,817.
So, if you want to build your savings pot without it being eaten away by inflation what choices do you have?
Time to ditch cash ISAs
For a start, you should ditch your cash ISA and move to shares. Shares are a much better guard against inflation for several reasons. First of all, many stocks currently support a dividend yield that is greater than the rate of inflation today. The FTSE 100‘s dividend yield today is around 4%, so all you need to do to beat inflation is buy a low-cost FTSE 100 index fund.
What’s more, company earnings are well protected against inflation as inflation is driven by businesses raising prices. Higher prices translate into higher revenues which translates into higher profits for investors. While earnings won’t be growing in real terms, the growth will offset inflation and all else being equal, should translate into a rising share price.
The most comprehensive data on equity returns and inflation has been compiled by Swiss investment bank Credit Suisse. Analysts at the bank looked at the real performance of UK equities, bonds and interest rates over a period of 118 years from 1900 to 2017. They found that over the period (which includes two world wars and numerous economic crises) UK equities produced an average annual real return for investors of 5.5%. Cash on the other hand, (represented by short-term government bonds) only generated a performance of 1% per annum after adjusting for inflation.
Fancy an extra £12,897?
A performance gap of 4.5% will make a tremendous difference to your savings over the long term. For example, £1,000 invested at a rate of 5.5% for 50 years would grow to £14,541, assuming all interest is reinvested. Meanwhile, the same amount invested at just 1% would be worth just £1,644 when you withdraw it after 50 years.
So overall, this data clearly shows that if you want to beat inflation and retire comfortably, you should ditch cash and move your money into stocks instead.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.