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The money illusion: Prudence won’t protect your cash from inflation

Interest rates don’t match inflation but investment in risk assets can pay off in the long term

The ECB has increased interest rates yet again but deposit rates remain stubbornly low, while inflation persists at around 6 per cent. Savers and investors seeking to preserve, let alone grow, the value of their hard-earned money are finding the going tough, to say the least. However, we may be beginning to see the tunnel, if not the light at the end of it.

“The high inflation environment is uppermost in people’s minds,” says Bank of Ireland chief investment strategist Kevin Quinn. “We find that in all our surveys. At the same time, we are seeing inflation falling, albeit at a slower rate than we might have hoped. Interest rate increases have come through at an unprecedented pace but they may well be at or near the peak now.

“The markets and the central banks have been tussling over this for the past year or more. We may now be seeing the other side. The market is pricing for decreases from the first or second quarter of next year. Rates will remain elevated but they will be going in a different direction.”

In addition, the markets see inflation getting closer to the policy target level of 2 per cent next year.


“The feeling is that it will be in the late twos or around 3 per cent,” says Quinn. “Inflation will still be with us but will be more moderate. The slow pace of interest rate falls means they will remain higher than pre-pandemic levels for longer than it took them to rise.”

That means the returns available from cash and bonds will be higher than they have been over the past decade and more.

“A conservative multi-asset fund now has a more powerful set of tools at its disposal,” he points out. “This type of fund, with between 40 and 60 per cent fixed income allocation, might have found the going a bit difficult in past years but will do better in the coming years.”

In this context, Quinn points to a number of quite cautious multi-asset funds available through Bank of Ireland which have delivered returns varying from 3.3 per cent to 6 per cent in the year to date.

But what should savers and investors do in the current environment?

“There is not a one-size wealth management offering,” says AIB head of customer financial planning Michael Cosgrave. “When we approach growing a customer’s wealth through savings, investments or retirement planning we are looking at their short, medium and longer-term plans.

“Short-term plans might include standard savings products like regular savers and/or fixed terms to benefit from saving interest rates and leave savings more accessible. For a longer-term goal with a five-year timeline and beyond, such as child’s education, Cosgrave says people would benefit from an investment-type product where they can make regular and lump-sum contributions over the period.

“There is a range of investment funds that a customer can invest in, depending on their level of risk,” he adds.

Cosgrave acknowledges the importance of customers always having an emergency fund that they can access quickly regardless of interest rates and inflation. “However, we regularly see that customers are leaving too much of their money in cash as they feel that they are not wealthy enough and/or don’t know how to access alternative options. Meeting a financial adviser can really help them to take that next step,” he says.

RBC Brewin Dolphin investment strategist Daniel Moroney agrees that people need to put aside money for short-term needs and emergencies but emphasises the need to protect the value of their other savings from the ravages of inflation.

“Many people miss the point that you have to compare the returns on your money to inflation,” he says. “You need to subtract inflation to get the real rate. Everyone instinctively understands this. But while we have seen the banks increase deposit rates for a very narrow cohort of savers, they are still not getting a rate that will keep up with inflation. Even if a call deposit account went up to 2.5 or 3 per cent, lots of people would think that it’s good that they are getting paid interest again instead of a zero rate. But if inflation has moved from 3 per cent to 6 per cent there is no real difference.”

This is known as the money illusion in the behavioural psychology of finance, Moroney explains.

“There is a natural belief that three must be better than zero,” he says. “But you need to protect the nominal purchasing power of your money. If you are getting a 3 per cent return on your money and inflation is 6 per cent, its purchasing power is still falling. They may think they are doing something prudent and safe but the damage inflation can do to an individual’s personal wealth over 10 or 15 years is terrifying.”

The only real way to protect that purchasing power – or, indeed, to increase it – is by investing at least some of your money in risk assets such as equities.

“The ability to take a longer-term view is hugely advantageous,” says Moroney. “That opens up the possibility to look at assets which can be more volatile in the short to medium term. If you have a portion of your savings that you don’t need to access for 10 or 15 years, that’s where you have the opportunity to look at equities in a responsible manner.

“But make sure to get advice and go in with your eyes wide open. You need to understand that value can fluctuate up and down. If you have a diversified portfolio of good-quality assets, you will generally be rewarded for investing in more volatile assets over the longer term.”

There are no guarantees, however. “Nobody has a crystal ball that they can foresee economic and market movements,” says Cosgrave.

“The best advice is to align your risk appetite with an investment strategy that is well diversified across a range of asset classes, geographies and business sectors or industries. Choosing a ready-made portfolio in the form of a multi-asset fund like one of our four Fusion funds is a great way to ensure your portfolio is diversified and managed to stay appropriate for that specific risk category.”

Barry McCall

Barry McCall is a contributor to The Irish Times