A clever way to beat inflation

When the rate on even the top-paying instant access account doesn't match inflation, it's time to think about other ways to grow your savings.

There’s no doubt about it, the rates offered on most savings accounts are rubbish at the moment. Some instant access accounts pay as little as 0.2% a year and even the top-paying instant access account –  the Santander Flexible ISA (issue 3) – only pays 3.3% a year. Yes, this tax-free account trashes most of its rivals, but the return is still well behind inflation which currently stands at 5.3%.*

If you’re willing to lock your money away for a year or more, you can get a better return from various fixed rate bonds. But as Neil Faulkner shows in Why long-term savings accounts are a waste of time, the higher returns aren’t large enough to make the greater inconvenience worthwhile. For example, the top two-year Fixed Rate Account only pays 3.96% a year.

Link to inflation

Another option is to go for accounts where the interest rate is linked to inflation. BM Savings is currently offering a 5-year bond where you’ll receive 1.5% plus inflation for each year. That’s a very nice return but, on the downside, your money will be locked away for five years. Several other providers are offering similar inflation-beating products, but with all these accounts, your money will be locked away for a long time.

A better way

Given that your money has to be locked away for five years to get the best return, I reckon that many people should consider investing in the stock market as an alternative way to beat inflation.

Don’t get me wrong, I realise that investing in the stock market is riskier than sticking your money in a savings account or a cash Isa. And, as with the BM Savings account, you'll have to think long-term. But if you're prepared to do that, I think it's the best solution for many people. 

Yes, stock markets are volatile – we’ve seen that over the last few years – but history shows that in spite of the volatility, shares normally do well over the long-term.  The secret to investing in the stock market is to stay calm when share prices are falling and wait for those prices to go back up in the fullness of time.

That raises the question: how long should you have to wait? Or, to put it another way, how long is long-term?

Well, I think these figures from the latest Barclays Equity Study can help us answer that:

Equity performance

The above table illustrates the performance of equities (shares) for different holding periods. It compares the relative performance of cash in a building society, gilts (government bonds), and an investment in the UK stock market as a whole.

The first column shows that over a holding period of two years, shares outperformed cash in 73 out of 111 years. So the probability of shares beating cash over a two-year period is 66%. Not bad, but there’s obviously still a good chance that you’ll regret your decision if you invest in shares for just two years.

Let’s now look at what happens if you hold your shares for five years. Now the probability of outperformance rises to 75%. Pretty good, but there’s still a significant risk that you’d be better off putting your savings in cash or gilts.

However, when it comes to the next five years, I think the probability of outperformance is higher than 75%. I say that because the stock market has performed badly over the last ten years. After that decade of poor performance, shares look relatively cheap at the moment and I reckon the stock market will probably do pretty well over the next few years.

And anyway, even if shares don’t outperform cash, that doesn’t necessarily mean that you’ll suffer a big loss if you invest in shares. The noughties are generally seen as one of the stock market’s worst decades, yet if you had been invested in the UK stock market for the ten years to December 2010, you would have received a real return of 0.6% a year. Yes, you’d have done better in cash or bonds, but investing in the stock market would have still enabled you to beat inflation.

I accept that investing in the stock market does carry risk. If you put your money into UK shares now - via an index tracker fund - and left it there for five years, there’s a chance that you could end up losing a chunk of your cash. The point is, I believe  that the chance is lower than you might think. For many people, the stock market is a clever way to beat inflation.

More:  This tax-free account beats inflation | The secret to becoming rich

*This is inflation as measured by the Retail Price Index (RPI) which is my preferred measure of rising prices.