Inflation and its effect on savings

Saving is the bedrock of good personal financial planning. Whether it is saving for children’s education, major purchases or retirement, putting money aside for the future is just good sense. There are many options available for those wanting to save or invest money – from bank deposit accounts to shares, property to government bonds. However there is a silent and invisible threat to saving that can affect each of these investments and undo a lot of the good work of the saver; inflation. Therefore understanding inflation and its effect on savings could be the deciding factor between a future of financial wellbeing or woe.


Currently, many developed economies are in the financial doldrums or even worse. Governments are struggling with deficits and many people have experienced, in real terms, declining pay levels for a number of years. One of the only things that have made the lack of pay rises bearable for many people is the fact that inflation has been under better control than it has in the past. However, many leading politicians and economists are calling for a relaxation in the so called ‘austerity’ measures and greater economic investment to try to kick start moribund economies. If this happens there is a good chance that inflation will rise; something that will have a profound effect on people’s savings.


What many people do not realise is that despite earning interest on savings or receiving a return on their investments, inflation may actually be causing them to lose money. To understand this it is important to understand the distinction between the nominal rate of interest and the real rate. The nominal rate is the reported or published rate of interest or return. By subtracting the inflation rate from the nominal rate you get the real rate of return. It may come as a shock to many savers with funds kept in the bank that their real rate of return is likely to be negative; in other words their investment is  actually losing money.


This situation is of particular concern when applied over a long period of time, such as when people are saving for retirement. An investment that consistently produces a negative real return over many years can lead to genuine hardship when the time comes to stop work. That would be an absolute travesty for someone who has spent a lifetime thinking they were sensibly saving for their future.


Academic studies have shown that the performance of different types of investments can vary according to the level of inflation. Shares, for example, do well in periods of low inflation but suffer when it is higher; in these periods, investing in gold generally produces better returns.


The solution for the saver and investor to cope with the effect of differing inflation is to ensure that they diversify their investments in different asset classes. The best way for most people to do this is to invest in a multi asset portfolio like that offered by Infinity’s partner Bestinvest. The spread of assets across seven different asset classes protects against the negative effects of inflation and helps money grow regardless of the prevailing economic conditions.


Related Post: How to Protect Savings From Inflation

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