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Interest rates in the developed world have remained very low or even negative, ever since the global financial crisis of 2008/2009 and investors have struggled to extract any kind of meaningful yield from the asset class known as cash.
This is particularly challenging for retired individuals who need income but understandably do not wish to take risks with their capital. The biggest problem is that cash interest rates are below inflation and in real terms, this means one’s capital is eroding in value. For example in the UK, interest rates have averaged under 0.5% p.a during the last 10 years, whereas inflation has averaged over 2% p.a. Nowhere near enough to preserve the real value of your capital.
Interest rates will only rise if economic growth accelerates on a sustained basis or inflation increases to such an extent that if left unchecked, it could threaten financial stability. Neither scenario is evident in many developed economies at this time.
So what are the alternatives?
If one seeks a yield greater than cash, some element of risk will need to be accepted. It’s the old risk v reward conundrum. Of course, cash is essential within a portfolio for short-term and emergency needs but once that nest egg is established, what can an individual invest in for greater returns?
Fixed Interest Securities:
Government bonds were traditionally an option for a potentially higher return than cash but within a ‘low-risk’ framework. However the current yield from developed country government debt has also fallen to the point that even these assets do not protect against inflation. Corporate and emerging market debt may offer higher yields but go hand in hand with a higher risk profile which may be too much for some.
Once cannot compare cash with stocks from a risk perspective but they offer the potential of a yield greater than cash over the long-term and history has proven that. However one must accept that stocks fall as well as rise in value, and dividends from them are not guaranteed.
Equities are one of the few asset classes which currently offer a yield above inflation. While many companies have cut or suspended dividends during the COVID-19 crisis, there is still potential for the share price to rise as well as the future prospect of healthy dividend payouts resuming. When the yield on cash and bonds falls when interest rates are low, the capital value of equities tend to out-perform. Looking ahead, we should see corporate profits and dividends recover more quickly than rising interest rates as we ease out of the COVID-19 pandemic.
If you are concerned that inflation is eating into the purchasing power of your cash reserve, then accepting some risk and investing excess cash in a sensibly diversified mix of equity-based investments like mutual funds, index funds and Exchange Traded Funds may solve your dilemma over the long-term.
If you are looking to earn an income from your investments, you might want to consider equities for at least part of your excess cash for the foreseeable future.
Contact us to find out how we can help you protect your capital against inflation.