Having a savings account is seen as sound investment planning for the future, but having a lot of cash can cause problems. Inflation will erode your savings, reducing the total value and eventually delivering a negative real return over time.
For example, if you had £2,000 worth of savings and inflation was 3%, after 10 years the spending power of your money would be £1,488. If inflation increased to 6%, your money would only be worth £1,117.
Having an interest rate that, after tax, gives a higher return than inflation will help. But for better returns, as soon as you've got your emergency fund stashed in a savings account, look to the stockmarket.
For instance, if you had invested £1,000 in the average UK All Companies unit trust at the end of April 2005, five years later you would have had £1,348.95, according to Lipper.
The same £1,000 in an average rate (1.95%) instant access savings account would have grown to £1,101.49 – almost £250 less than in the stockmarket fund.
If it's your first time there are ways to take some of the stress out of investing. Going for a fund rather than investing in individual shares will allow you to gain instant diversification.
Having a broad spread of investments ensures that if something does go wrong with one, it won't completely wipe you out.
A regular savings strategy can also deliver benefits. Putting away a set amount every month not only fits with the way we receive money, but it also harnesses the power of 'pound-cost averaging'.
Because the price of funds varies from day to day, if you invest on a monthly basis you'll buy a different number of units each time.
Rhys Francis, director of independent adviser Lorica Consulting, explains: "It may sound strange, but it can be good news when the value of your investments falls – this is the case if you're investing regularly and the price eventually recovers."
Say, for example, you invest £100 a month in a fund. If in the first month the price of units is £1, you buy 100 units.
One month on and the price has fallen to 80p, allowing you to buy 125 units. The next month the price has recovered slightly at 90p, and you buy 111 units.
When you next invest, the price has increased to £1.05, meaning your 336 units are worth £352.80. By comparison, if you'd invested the full £300 at the beginning of the period you'd have 300 units worth £315.
The downside, however, is that if the price rises, you'll buy fewer and fewer units. But as not many of us have the luxury of lump-sum investing, at least you'll get some benefits in volatile markets.
Financial services compensation
In addition to thinking about your overall savings and investment portfolio, it's also important to know where you stand if something goes wrong, as this can affect where you put your money.
If a savings or investment company that is regulated by the Financial Services Authority stops trading or is declared to be in default, the Financial Services Compensation Scheme (FSCS) can provide compensation.
There are limits, however, and it's worth spreading your money around so you don't exceed these. The maximum you will receive if a savings or investment firm stops trading is £50,000.
Importantly, these limits apply per person per firm, so if you have a joint savings account, the first £100,000 of your savings will be protected.
Additionally, because it applies per firm, check you don't already have money with that company.
For example, before Alliance & Leicester's business was formally transferred to Santander at the end of May 2010, savers would have received £50,000 compensation for deposits held in each of the two banks. Now, you'd only get £50,000 across the two.
More information can be found on the FSCS website at fscs.org.uk
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.
The Financial Services Compensation Scheme is the compensation fund of last resort for customers of authorised financial services firms. If a firm becomes insolvent or ceases trading, the FSCS may be able to pay compensation to its customers. Limits apply to how much compensation the FSCS is able to pay, and those limits vary between different types of financial products. However, to qualify for compensation, the firm you were dealing with must be authorised by the Financial Services Authority (FSA).
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).