As much as we may want to ignore this invisible cash predator that preys on our money, inflation is devaluing our cash at an alarming rate. With prices being raised each year, our money is losing value as we speak – so what can we do with our money to avoid this? Investing of course.
By investing in an All-Share ETF (either the S&P 500 or FTSE), we mitigate the impact of inflation on our cash. During 2020/21, the S&P 500 gained 27.81% whilst the FTSE All-Share gained 21.96% during the same period! Much better than the 2% you’d lose to inflation if you were to keep it as cash.
As great as this sounds, it would be best to give you the full picture on exactly what inflation is, what causes it and some potential downfalls to investing to defend against inflation.
What is inflation
Inflation is essentially what it says on the tin. It is the gradual rising (inflation) of prices over time. Remember when you were able to buy a Freddo for 10p in the corner shop? Well, the reason you almost need a mortgage to buy one is because of our dear-friend, inflation.
What drives inflation
There are a few different types of inflation that causes the price of goods to rise. These are Demand-Pull, Cost-Push and Built-In inflation.
Before we jump into the different types of inflation – we need to discuss some economics fundamentals, namely surrounding supply and demand. As we know, when we have a limited amount of supply for a product and lots of people want it, prices rise to accommodate for this.
Let’s say you’re at school and you’ve got a chocolate bar, one of your friends says ‘ah let us have that, I’ll give you 50p’, soon all of your friends are fighting over who gets it until finally, it’s sold for £2. Here we’ve got a very small supply of the chocolate bar (only 1) and a lot of demand (all of your friends wanting it) – this is fundamentally why the price rose.
The reverse is also true, if we’ve got 1,000 chocolate bars and only 3 mates – you’re going to want to discount the prices quite a bit in order to sell as many as you can so you’re not left with 997 bars. The drop in price is due to the surplus of supply (in the chocolate bars) and the restricted demands (only 3 friends).
Now we’re ready to move onto the different types of inflation.
Demand-Pull inflation
Referring back to our example of the 1 chocolate bar and all of your friends wanting it. The demand is pulling the price up – i.e. when the first friend offered you 50p and it eventually sold for £2.
This is Demand-Pull in full motion. The demand has pulled the prices up – what do we call rising prices? Inflation!
Cost-Push inflation
For cost push, we will use the example where you’re a clothing manufacturer. You buy your materials from abroad and make all of your clothes in a UK factory. However, due to the UK leaving the EU, new taxes and levies have been added to your material imports meaning that the cost of materials has risen by 5%!
You’re already operating with quite a slim profit margin so if you absorb this 5% cost, it will push you into the red – what do you do? You are forced to pass this 5% cost onto the customers by increasing prices slightly.
Although it is a different driver from the high-demand, low-supply, the end result is the same – prices have risen.
Built-In inflation
This is more related to wages and salaries. With Cost-Push and Demand-Pull inflation making things more expensive for everyone, people are struggling to get by with what they are being paid – they march into the office and demand a pay rise!
Although this makes complete sense, it will mean that the employer’s business will incur more costs because they’re not only shelling out more for wages and salaries but they’re also paying more in Employer’s National Insurance (13.8% of gross wages) to HMRC!
So what does increasing costs of a business mean? We’ve just mentioned it… Cost-Push Inflation. And so increasing business costs push up living costs and so the spiral continues.
There are lots of different ways that the government can intervene to curb this seemingly never-ending spiral but this would take a while to explain so we’ll leave that for now.
How does it devalue our cash
We’ve pretty much answered this in the above when we covered inflation and the different ways it can come about, however, we’ll cover it once more for good measure.
If our cash is earning a measly 0.05% interest in our savings accounts, all the while, the cost of basic necessities like bread, milk… chocolate?, are all rising – what our money could once buy us, it now cannot.
So what’s the solution? Well – anything that will allow our idle cash to gain by more than 2% (or the current rate of inflation) each year! Unfortunately, the current interest rates offered on bank accounts is abysmal so it looks like we’ll need to dabble in investing!
What can we invest in?
You have absolutely tonnes of options that you can choose from when we talk about investing and it should mainly be based on what you can afford and are comfortable with.
Property
This is a popular one as it seems that over the course of 10-15 years, house prices in the UK have doubled – this is the equivalent to a 100% return on investment.
However, just as a hedge against inflation, this might not be suitable for a few reasons:
- The process of buying and selling can be long and expensive;
- Property requires different ongoing costs like land rent (for leasehold), utilities, repairs, wear & tear, etc.; and
- If you’re not a cash buyer, you end up needing a mortgage with comes with its own set of complications!
Commodities
Another investment is commodities – this could be gold or coins, something of this nature. These are a great investment as they do tend to rise in value and almost always beat the rate of inflation.
However, similar to property, it has it’s suitability issues:
- It can be hard/lengthy process to liquidate your investments;
- You might be wrong and actually lose value;
- They’re physical items and at risk of being stolen or damaged.
Shares
The final investment we’ll talk about is shares.To get started, all you need to do is Google ‘investment platforms’ and get cracking! I’ve actually written an article called ‘Cheapest Way To Invest In Shares: Don’t Waste Money’ where I’ve actually picked a handful of investment platforms and compared their costs so this is definitely a good one to check out if you wanted to choose this route.
If you’ve read the second paragraph in bold, you know this is our investment of choice for hedging against inflation. However, you need to be aware that it does come with it’s downsides.
Potential downfalls to investing in shares
It would be irresponsible of me if we didn’t go over the downfalls and everything you need to be aware of when we speak about investing. There is a lot of work that needs to be done to ensure you’re happy with where you money is invested as it’s ultimately going to be riskier than it sat in a Cash ISA earning a staggering… 0.01%.
So without further ado, let’s get into it!
Returns are not guaranteed
I know it sounds silly to say but investing is, and never will be, a sure thing. The only way you can keep your money 100% risk free, is by keeping it in cash under your mattress – that’s also the best way to ensure that inflation takes you for every cent/penny you’ve got.
Some investments perform much better than others (and some perform much worse) so you may wake up and find that instead of just beating inflation with a meager 2% return, you’ve made 30%! But you could also find that you’ve only made 1% and still not catching up with inflation.
Risk money might actually go down
In addition to those returns not being guaranteed, there is also no guarantee that the investments won’t fall! That’s right – you would have been better off by keeping the cash under your mattress after all!
I would like to point out here, if you don’t do any research and you just invest in the first thing you see (or just because someone said it would be a good investment) then you’re not investing – you’re gambling. This is massively different from what we’re talking about here.
How best to reduce these downfalls
Research, research and more research
This is probably the most important step in your journey to beating inflation. Obviously if you’re putting your hard-earned money somewhere, you want to ensure it’s as safe as it can possibly be!
On the flip side, there is of course some risk to be associated with whatever you decide to invest in, regardless of the amount of research you do, however with higher risks come those higher rewards we’re looking for.
For shares, you can read up on the latest company news by googling the company name and clicking on the ‘News’ page on Google search. You can also read their latest company accounts and reports to get an understanding of how strong they are financially and what their plans for the future are.
When dealing with Bonds – your safest bet is to research the bond grading and exactly what the loan is funding. The higher the bond grade, the more secure it is as an investment i.e. the company is very unlikely to default on the bond.
Finally, when looking at funds – just make sure you familiarise yourself with the fund factsheet and that you’re happy with the manager, what the fund is invested in and that you understand key figures from the factsheet.
Diversify your investments
When we talk about diversifying our investments, all we mean is we make sure we distribute our proverbial eggs into a few different baskets. This means that if one investment goes through the floor, we’ve got our other good investments that prop us up and keep us in the green.
How do we diversify our investments
We actually dive super deep into all things diversification in my article ‘Investing: Which Investments Don’t Lose You Money?’ so if you haven’t already – give that a read!
But the long and short of how to diversify your investments is like – you can diversify in the following ways:
- By country;
- By industry; and
- By investment type.
By ensuring you have multiple investments spread across various countries, industries and investment types (i.e. bonds, shares, funds), you safeguard against any one investment causing your portfolio to fall.
Our Golden Ticket solution
The best way to achieve all of the above and maximise your chances of beating inflation are to invest in ETFs.
An ETF is an Exchange-Traded Fund – they are indexes or trackers that follow a certain bucket of investments. A great example of an ETF would be the FTSE All-Share. This ETF tracks the performance of EVERY SINGLE SHARE that is openly traded on the FTSE.
What does this mean? It means you have a finger in pretty much every pie in the FTSE – the ULTIMATE diversification. Apart from the fact that it’s specific to the FTSE and therefore at the mercy of the UK economy…. But other than that… ULTIMATE diversification.
I personally have invested in the S&P 500 (the Standard & Poors top 500 US stocks) and the FTSE All-Share so that I’m diversified across both the UK and US markets! And I’m happy to announce that I have beaten inflation by 5% over the past year… not bad aye?
Summary
So to round of this inflation-busting post, let’s recap what we should now know having finished reading this article:
- What is inflation;
- What drives inflation;
- How inflation devalues our cash;
- Investment types;
- The importance of a diversified investment portfolio; and
- A simple tracker fund is your best bet to beat inflation.