After the Bank of England meeting last month, interest rates were kept on hold at 0.75%. You have to go back over a decade to the financial crisis to see a time when interest rates here in the UK were over 1%. That is great news if you have a loan or mortgage, but less so for savers. And this is not just a UK-centric problem as rates the world over are at extreme lows, with parts of Europe even seeing negative interest rates.
Against this backdrop, cash sitting in your bank account is really not going to make you rich. And a cash ISA is little better. Therefore, when looking at how you are going to make your money work for you this year, I would avoid a cash ISA and look to a Stocks and Shares ISA instead. Even then, you need to be prudent in your choices to make sure you maximise the potential for returns in a low-interest-rate environment.
Filled to the brim
The ISA allowance for this year is £20,000. I myself am going to try to use as much of this allowance as I can afford, rather than leaving any money I have to spare sitting in cash. My reason for this is that due to the low interest rates in the market, my ‘opportunity cost’ of holding funds in cash is high.
For example, if I had £10,000 in my account and decided to invest £1,000 in a stock that rallied 10% this year, I would have ‘beaten’ the cash returns by 9.25% on that £1,000. However, the other £9,000 that I left sitting in cash has not performed at all, and so overall, the performance of the whole amount is frankly poor. Investing as much as you feel comfortable stashing away really can help you to generate better returns as a whole.
Watch out for inflation
While we want to beat the interest rate as a basic level to ensure our money is generating us real returns, I am also keeping a close eye on inflation. This currently stands at 1.3%, but was as high as 2.1% last summer. Inflation means that even if I invest in a stock that pays me a dividend yield of 1%, I may not be making my money work hard enough.
My 1% dividend yield is beating the interest rate of 0.75%, but it is not beating inflation at 1.3%, and therefore the value of my money is being eroded by 0.3%. To solve this, I would look to target higher-dividend-yield stocks within the FTSE 100. That means those offering 5%+ in order to ensure that I am definitely beating inflation.
Overall, low interest rates do not appear to be about to end any time soon, and even if we did see a an interest rate hike this year, returns from cash would still not be exciting. By looking to maximise your ISA allocation to reduce that opportunity cost and by seeking high-dividend-yield names to beat inflation, you can give yourself a much better chance to generate solid returns.
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Jonathan Smith does not own shares in any firm mentioned. The Motley Fool UK owns shares of and has recommended Unilever. 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.