Battling the scourge of inflation

David Prosser looks at how investment companies can help protect the real value of your savings.

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Inflation isn’t beaten just yet. The latest official data suggests that while the headline rate of inflation is now coming down, it remains close to 9%, well ahead of the Bank of England’s forecasts. Worse, core measures of inflation appear to rising rather than falling. As a result, the consensus amongst economists is that further interest rate hikes from the Bank of England are inevitable.

For savers and investors, high levels of inflation threaten their wealth as well as increasing the day-to-day cost of living. The real value of your savings and investments will be eroded if the returns you earn on them do not stay ahead of inflation. How, then, to protect yourself?

Investment companies can be a good place to start. For one thing, many have a track record of paying consistent levels of dividend income – the AIC’s dividend heroes list includes 19 funds that have increased their dividend payments in each year for the past 20 years; some have a record going back 50 years or more.

The statistics on UK equity income investment companies underline the point. Right now, every single fund of this type offers an income yield of more than the 3.2% that the best easy access cash ISA pays. And more than half yield more than 4.25%, which is the best you’ll get from a fixed-rate cash ISA deal.

Now, those numbers are still well below inflation. But what you also get from investment companies is the potential for capital gains – something you won’t get from a cash savings account, or even from bonds in any substantial way. On a total return basis, the average UK equity income fund has returned more than 5% a year over the past ten years – comfortably ahead of inflation over the same period.

The comparison between cash ISAs and investment companies is one to be careful with, of course. In an investment company, where your cash is ultimately invested on the stock market or in other assets, there is the potential to lose money in nominal terms too. Share prices can fall as well as rise. That’s not true of cash savings.

The reality, however, is that if you want to protect your wealth from inflation, you have little choice right now but to take on investment risk. Anyway, the damage done by an inflation rate of 9% to cash savings paying 3% annual interest or even less is not to be underestimated.

In which case, investment companies are a potentially attractive way of taking that additional risk. One important reason for this is their unique ability to build up income reserves. Most collective investment funds must pass on the income they earn on their portfolios to investors in full; investment companies, by contrast, can build up reserve funds to supplement payments to investors in lean years for income, or in more challenging times. The effect is to smooth out distributions over time.

In time, no doubt, inflation will begin to ease back to the Bank of England’s target rate of 2%. But even then, cash savings will struggle to outperform – as interest rates come down accordingly, so will savings rates. Diversification into investment companies will therefore provide long-term benefits if you’re happy to take on additional risk in the shorter term.