It’s something so powerful that Albert Einstein called it the eighth wonder of the world, and for good reason, too.
No, it’s not King Kong; but instead the much mightier concept of compound interest (which is far less likely to run amok in New York City).
Compound interest is the return from an initial sum saved, plus the accumulated interest from previous periods of time. Think of it as interest on interest; gathering momentum slowly at first before snowballing into a significant amount over time.
For example, a £1,000 deposit into a savings account offering a guaranteed annual rate of 5% (which is optimistic, admittedly) will result in a total of £1,050 after the first year. The second year (providing the amount is left untouched) will result in a total of £1,102.50 as interest is calculated on the first year’s interest.
It may not sound like a significant increase, but left for the long-term, over say, 15 years will generate £1,078.93 in interest, effectively doubling your initial deposit.
Now picture the opposite. Inflation is essentially compound interest in reverse, eroding the buying power of your money if your income doesn’t keep pace with it.
If you understand it, you’re in the minority
According to The Organisation for Economic Cooperation and Development (OECD), 62% of UK adults don’t understand inflation, or how it affects their finances.
Inflation is the rate that the price of goods and services increase year-on-year. Much like the eighth wonder of the world mentioned above, inflation is compounded, however, inflation compounds the real terms loss (or reduction in buying power) of your capital or income.
There are multiple measures of Inflation. However, the Consumer Price Index (CPI) is the most commonly quoted. Each month, the prices of various products and services are compared with data from 12 months previous. The difference between the two values is presented as a percentage, showing how much the cost of living has risen.
The compound effect comes from the way that inflation is measured. As each new calculation is based on the year before it, it represents an exponential increase.
Why is this a threat?
As the cost of living increases, you will need more money to afford the goods and services you need to maintain your lifestyle. Your income will need to rise in line with inflation to sustain your current lifestyle. You are particularly at risk if your income is fixed, such as:
- A person receiving a pension (other than the State Pension, which is inflation-linked)
- A person who has not received an increase to their pay
Equally, any savings or investments you may have must offer returns that keep up with inflation or you will suffer a real-terms loss. Sure, you may have more money in the account than you originally did, but it will effectively be worth less.
In December 2017, the rate of inflation as measured by the CPI was 2.8% (Source: ONS). Any savings account or investment that doesn’t offer this will see the value eroded by however much it comes up short.
The importance of staying informed
With the relatively high levels of inflation we have been experiencing, it has never been more important to be financially literate with your savings and investments.
Unfortunately, research from the OECD suggests that this simply isn’t the case in the UK, with:
- 25% of people not monitoring finances closely
- 16% of people not paying bills on time
- 31% of people not properly considering purchases before making a decision
- 55% not setting long-term financial goals
The OECD suggests that seven in 10 people are actively saving money, but don’t understand how interest is affecting those efforts. Without understanding the effects of inflation, these efforts to save money could be in vain.
Taking time to consider how external factors affect your personal finances can ensure that you can plan ahead, and minimise (or eradicate) any erosion caused by inflation.
It may only seem like a minuscule amount being lost, but as compound interest shows, those small figures grow into something significant in the long-term.
How can I protect my money?
There are a number of ways to ensure that you are taking a stand against inflation.
The most effective way is to take independent financial advice. A professional adviser will be able to help work out exactly how inflation is affecting you, and put a plan in place to help you minimise erosion both in the long run and the short.
For more information, get in touch with Ben.