Is your wealth keeping up with inflation
How to Create a Great Financial plan for your life
Part 2. Is your wealth keeping up with inflation, especially with interest rates below zero?
Is your money in the bank?
This is a continuing series aimed to provide you with some thoughts, ideas and strategies when considering and planning for your financial future.
In the second part of this original series about “How to Create a Great Financial Plan for your life” let’s look at another fundamental planning (and savings) principle: How will inflation affect me, and how will my savings look after me in the future?
Sooner or later we do have to consider tomorrow: what happens in the future when perhaps we are not working and our income is not what it used to be?
In the first article of this series I wrote about the risk of relying on the State or government pension to fulfil your future income and cash lump sum needs.
A good adviser will suggest that you do not put all your eggs in one basket when saving and planning for the future.
Aside from pension plans, most of us realise that we need to keep a level of savings in reserve, and preferably this is a growing reserve, within a longer term financial plan.
Everyone knows that saving money after income taxes, state social charges and living expenses, is not an easy thing to accomplish. However what many people do not realise is that unless your hard-earned money is invested wisely, that savings reserve could in fact be going backwards, and literally declining in value, especially when compared to the current inflation rate.
What is inflation and the inflation rate?
Very generally, the definition of inflation is “A rise in the general level of prices of goods and services in an economy over a period of time.” When prices rise, your Euro/dollar/pound/Lire can buy fewer goods and services.
Inflation acts like erosion, reducing the buying power of your money, over time.
Consequently, you have lost some of your buying power. It just doesn’t feel like a loss because you don’t see the loss when looking at your bank balance.
If someone you knew kept $50,000 in cash hidden away for 15 years, and the average inflation rate over that time was 5% per year: then after 15 years the purchasing vaue of that money would be equal to approximately $23,160 – or in other words after 15 years you can only buy goods or services worth $23,160.
In the short-term a bank is a good place for your money. However when considering your needs for retirement or for the next five years or so, it will pay to consider where in fact you are choosing to save your money, and hopefully, attempting to grow your money (or at least keep pace with inflation).
Banks will pay you interest, however this income is taxed directly in your hands and may not keep pace with inflation whatsoever.
In June and September this year, the European Central Bank (ECB) has cut deposit interest rates from zero, to negative 0.2% (or -0.2%). This means that Italian banks (and all European banks) have to pay the ECB to hold their money! This reflects a determined plan by the ECB to encourage lending and bank investment within the economy, and to encourage investors in Europe to invest in the wider economy!
It also means that banks have little or no incentive to pay interest on cash deposited with them by their customers. Your bank statements will be telling you this story.
Accepting Risk to earn a return on your money
It is widely recognised that a key to all investing is to diversify your risk.
Diversification or by holding a variety of asset classes that maintain differing levels of risk within those asset classes, you can spread your risk in a broad fashion, such that volatile movements or poor performance in one area, has a much reduced or negligible impact on your overall portfolio or wealth.
Uncertainty and volatility are normal for investment markets. However your first strategy to deal with such volatility is effective diversification. Just like keeping all your savings in the bank is not diversified, neither is keeping 100% of your money in property, or in shares.
In this low interest rate environment, commentators widely recognise that investors have to make the decision: do they simply continue to hold cash on deposit and accept the cost involved, or do they take on some additional risk to earn a return?
This is indeed a dilemma in particular for risk-averse investors, when at present low risk investments other than cash may not be returning attractive or high levels of income or capital growth – this is normal however, since low risk investment cannot expect to earn high rates of return. This is the risk-return trade-off at play. A higher level of risk is rewarded with higher rates of return. Low levels of risk produce relatively lower levels of return.
However we can be more confident that investing in assets other than cash has a much greater prospect of generating returns in this environment – considering that interest rates at the ECB are negative!
In a future article we will look at the various asset classes and consider how you can use them to your advantage as an investor today.