Should you save or invest your money?
With interest rates at record lows and inflation creeping up which erodes the spending power of your pound, investing may seem like a good option. But with the prospect of getting less money back than you put into the stock market, it seems cash savings still have a place for many.
Online investment platform Evestor has created a flowchart asking individuals key questions about existing debt, rainy day savings and timescales to help guide you through whether you should save or invest your money (click on the image to enlarge).
Do you have existing debt?
If you have some spare cash at the end of the month, the first thing you need to ask is whether you have unsecured debts, such as with credit cards.
If the answer is yes, Evestor says you should pay off debts first before considering a save or invest action plan. It adds that any saver or investor should think in terms of their priorities, and to seek financial advice where needed.
If the answer to the debt question is ‘no’, Evestor’s next question relates to whether you have a ‘rainy day fund’ to cover unexpected expenses such as a car repair or boiler break down. For those who don’t have emergency funds, Evestor says it’s best to make sure you have a cash buffer first.
When will you need access to your money?
For those who think they may need their money back urgently, Evestor says generally, it is easier, quicker and cheaper to access savings. An instant access savings account, for example, will give you immediate access to your money if you need to withdraw it without penalties. By contrast, pension pots are not accessible until 55 at the earliest, unless in exceptional circumstances e.g early retirement. Some investments can be illiquid products, meaning it’s harder to gain access to your cash.
Tom Adams, head of research at independent savings adviser site Savings Champion, says holding cash over money in an investment gives people physical security and accessibility in the short-term.
He says: “While some savings accounts require you to lock your savings away for a period of time or give notice to access your cash, those savings for a short-term need such as a tax bill or a deposit on a house can’t take the risk that the capital may have gone down in value, especially when they need the money. For many, even if they are looking to invest, they should retain some cash for short-term needs and rainy day funds, as investments can be less accessible at short notice.”
Individuals need to think about timescales as savings tend to be for the relatively short-term, say up to five years, whereas investments are generally for the longer-term.
Maike Currie, investment director for personal investing at Fidelity International, says it’s wise to have a cash buffer. However in the long-term she says you’re far better off investing than leaving your cash in savings accounts.
Currie says: “While it’s always wise to have a cash buffer as part of your overall portfolio, staying in cash for the long-term is never going to be a sensible or feasible investment strategy. With interest rates on the floor and with the Bank of England showing little sign of hiking rates anytime soon, banks are likely to continue to offer very little or no interest on cash savings. With this in mind, you’re far better off investing your money rather than leaving it under the proverbial mattress if you’re after decent long-term returns.”
She adds that in addition to record low interest rates, rising inflation also has serious implications for both savers and investors.
“On top of record low interest rates, we have inflation hovering above 2% and set to climb higher. Higher inflation has implications not just on the everyday cost of living, but also on savings and investments as a low interest rate and rising inflationary environment is a toxic combination for people.
“As inflation erodes the value of the money in our pockets, we are left with less to save. Any savings kept in cash on near-zero rates will be worth less now than they were 12 months ago. With inflation rising and wage growth slowing, our savings need to work harder.”
Are you comfortable with risk?
If you’re without debts, you have a savings buffer for emergencies and you’re thinking for the long-term, the next question to ask yourself relates to risk, specifically, what are you comfortable with?
Evestor says a good rule of thumb is: the lower the risk the lower the return – and vice versa. It says savings are virtually risk-free – your money is guaranteed up to £85,000 per account in the unlikely event your bank fails – but they also offer very low rates of interest but at least savers receive a guaranteed amount of annual interest. Investments offer the potential for higher returns, either from capital or dividend growth, or both, but your money is at risk – that means you could lose money and you may not get back all you put in at the outset.
Adams says the fear of investing may mean people continue to save their money but in the current environment, it’s really important to shop around for the most appropriate savings account with the very best rates in order to make cash work as hard as possible, especially when inflation is comparatively higher than the rates on offer.
He adds that new Financial Services Compensation Scheme (FSCS) rules mean that funds received following certain life events, for example inheritance or divorce, can be protected under the Temporary High Balance rule. This states up to £1m per person, per banking licence, is protected for six months, after which any remaining funds will need to be split within the normal FSCS limit, currently £85,000, if the money is to remain fully protected.
Despite the bolstered protections available on cash, Currie says that stock markets have offered better returns on cash and investments benefit from dividends.
She says: “While investing in equities in the current climate may be more risky than stashing your cash under the mattress, history shows that over the long run equities have significantly outperformed cash and continue to be the sensible choice for anyone looking for long-term real returns.
“Our calculations show if you had invested £15,000 into the FTSE All-Share index 10 years ago you would now be left with £26,049. If, however, you had invested £15,000 into the average UK savings account over the same period, you would be left with a paltry £15,767. That’s a difference of over £10,000 – too big for any sensible saver to ignore.”
Currie adds that when investing in stocks and shares you not only benefit from the growth in the underlying companies, you also benefit from any dividends that are issued to reward shareholders.
“Depending on your needs, you can either take the natural income that is generated from dividends or choose to reinvest the money. If you choose to reinvest your dividends, you can really supercharge your returns, especially if you are investing over the long-term as you will benefit from the magical power of compounding.”
Don’t forget about pensions
Another point to note is that rather than saving or investing, you can do both via a pension. Currie says rather than leave your money sitting in cash over the long-term, a sensible strategy could be to invest your money into a pension.
She explains that one of the key attractions of saving into a pension is that when you pay into it, you get tax relief on any contributions you make (up to the annual allowance) at the highest rate of income tax that you pay. For a basic rate tax payer that’s 20% and for a higher rate tax payer that’s a generous 40%. This means for every pound you put into a pension, you effectively only have to pay in 80p or 60p respectively.
Adams cautions that as pension investors reach retirement, there comes a point where moving money from equities to cash may be a sensible approach.
“A person in their 90s may not necessarily be able to afford to keep money in equities for the longer term not least as they may need to start drawing on that money to supplement their income, at a time when every penny counts,” he says.