Investing in the stock market is risky. Cash is safe. Investments can go down as well as up. Cash is safe. You may get back less than you invested. Cash is safe.
You’ll probably have read many warnings about the dangers of investing in the stock market. But have you ever read any about the risks of saving cash?
Here I’ll explain why… for anyone aiming to build a £1m nest egg, the risk of failing to achieve your goal is higher for a cash saver than for an investor in the stock market.
Crummy cash
The best easy access Cash ISA I can find at the moment pays interest of 1.46%. The trouble is, UK inflation is running at 1.7%. This means while your savings are nominally rising at 1.46%, inflation is eating it all away and another 0.24% to boot. In other words, the real value of you savings is falling.
Let’s have a quick look at how this works in practice, using the example of a saver who puts £500 a month into the Cash ISA. The table below shows what happens over five years (numbers rounded to the nearest pound for simplicity).
|
|
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
|
Capital (£) |
6,000 |
12,040 |
18,168 |
24,386 |
30,694 |
|
Interest (£) |
40 |
128 |
218 |
308 |
401 |
|
Total (nominal) (£) |
6040 |
12,168 |
18,386 |
24,694 |
31,095 |
|
Total (real) (£) |
5,993 |
11,972 |
17,937 |
23,887 |
29,823 |
Over the period, the saver deposits a total of £30,000 in the Cash ISA, earns over £1,000 in interest and, at the end of the five years, has savings of £31,095. However, taking into account inflation, the real value has fallen to £29,823. That’s a £177 drop in the purchasing power of the £30,000 deposited.
On this basis — an interest rate of 1.46% and inflation at 1.7% — it would take 213 years to build a nest egg with a real value of £1m, and you’d have to invest a nominal total of £1.3m to achieve it.
Relative returns
The good news for savers is that cash has delivered a positive real return over the longer term (since 1899). The bad news is it’s averaged a paltry 0.7%, according to a study by Barclays. It would take 111 years to reach the magic million, saving £500 a month at 0.7%.
According to the same study, the British stock market has delivered 4.9% a year in real terms. At this rate of return, a £500-a-month investor would build a £1m pot in 46 years. As you can see, the historical rates of return on cash and stocks suggest investing, not saving, is the way to go if you’re looking to build serious wealth.
How to invest
A popular way to invest in the stock market is with a low-cost FTSE 100 index tracker. This tracks the returns of the biggest and most successful 100 companies listed on the London market, including Shell, HSBC, GlaxoSmithKline and many other familiar names.
Your investment buys you a small stake in each of these businesses, and your stake becomes more valuable if their profits increase over time. Mostly they do. This is why the British stock market has that long-term real-rate return of 4.9%, despite two world wars, a depression, numerous recessions, and other events that have temporarily set the market back.
This is why, I say, if you’re aiming to build a £1m nest egg, forget a Cash ISA and look to the stock market to help you achieve your goal.