Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

The financial markets are dominated by one key theme at the moment - inflation. But what do rising prices mean for our personal savings and investments? And what can we do to protect ourselves?

Everyone’s talking about it, but how serious is the inflationary threat? Compared with previous periods of sharply rising prices like the 1970s, the UK’s latest inflation rate of 2.1% and even the 5% recorded in the US last month might not seem to be much of a problem.

But it’s worth noting that in the years running up to the big inflation spikes in the 1970s, prices were rising at similar levels to today. Like bankruptcy or addiction, inflation can become an issue slowly at first then quickly.

It’s also worth remembering that even just 4% inflation will halve the purchasing power of your money in only 18 years. That could mean the difference between a comfortable retirement and a much less enjoyable one. As people live longer, we should all be planning for at least an 18-year retirement.

So, a key question is whether the recent increases in inflation are temporary or here to stay. At this week’s meeting of the US central bank, the Federal Reserve, the tone shifted a little bit from confidence that price rises are transitory to recognition that they might be a bit more entrenched.

US rate-setters now expect to start raising interest rates to combat higher prices in 2023, a few months earlier than they thought likely only three months ago.

Here in the UK, Andy Haldane, the Bank of England’s chief economist, has talked of the UK economy bouncing back like a ‘coiled spring’. Here, too, interest rates won’t be at rock bottom for ever.

The financial markets have started to factor higher inflation into their thinking. Bond yields rose quite sharply this week after the Federal Reserve’s announcement. But what are the implications for the rest of us? How might rising prices affect our personal finances?

How we spend it

Higher prices are starting to show up in many corners of the economy as higher demand for goods and services runs ahead of the economy’s ability to increase supply. In part this is a temporary phenomenon that reflects year on year comparisons with the first Covid lockdowns in early 2020.

In part, however, the response of governments around the world to rebalance their economies in favour of the lower paid who were hardest hit by the pandemic is expected to lead to higher inflation on a more sustained basis.

The prices of anything from a haircut to a second-hand car are higher than they were a year ago. Covid restrictions mean restaurants, for example, can serve fewer customers and they need to charge more to cover their costs. House prices are rising in some areas as demand for more space increases as people look to work more from home for the foreseeable future.

Action: Decide whether your outgoings are necessary or a nice to have. Don’t be too quick to return to the spending patterns of the pre-pandemic world - did you really use that gym membership? Was the coffee on the way to the office just a costly habit that you can do without? But, equally, cut yourself some slack. You may have saved some money over the past year or so. It’s not unreasonable to spend a bit of it now.

How we finance it

Rising inflation will in due course lead to higher interest rates which naturally will feed through into higher mortgage rates.

There is actually little sign of this just yet. Home loans remain at very affordable levels, especially for borrowers who have some equity in their house.

But now might be a good time to explore locking in a fixed rate mortgage. You will have to pay slightly more if you are looking for longer-term security (say five years or more) but you may look back with relief that you fixed your outgoings while inflation still looked like tomorrow’s problem.

Don’t forget to check the terms of your current loan before making a change. Most fixed rate mortgages come with an early redemption penalty which can negate the benefit of locking in a new rate. There’s normally a one-off fee for setting up a new mortgage which needs to be factored in too.

Action: compare the cost of your current mortgage with what’s available on the market today and weigh up whether a change makes sense.

How we save it

Interest on cash savings remains very low and is almost certain to be less than the current rate of consumer price inflation. That means that you should not hold more than you need in cash. It will be falling in value in real, inflation-adjusted terms.

However, it is worth considering why you hold some of your money in cash. It’s not just about the return you are earning on it.

A cash reserve can protect you from being forced to sell your investments at the wrong time - after a fall in financial markets. A good rule of thumb is to have at least six months’ worth of everyday expenses to hand in the form of cash. You could make a good case for having even more than this to protect you from market volatility.

The second reason to have some cash available is the option it provides to take advantage of those ups and downs in the market. If you are fully invested and share prices fall you need to have some dry powder to capitalise on the opportunity.

Action: make sure that you have at least six months’ worth of cash in reserve. And if you are taking an income from your savings and investments make sure that you are automatically replenishing that cash reserve month by month.

How we invest it

How can you protect your portfolio from the ravages of inflation? Rising prices are a kind of hidden tax. And, as with any tax, there are things you can do to minimise your exposure.

Some assets are more vulnerable to inflation than others. Principally, anything which pays a fixed income and/or offers a fixed capital return. Bonds are the obvious case in point here.

Bonds, which pay a fixed income (or coupon as it is sometimes called), become less valuable to an investor as interest rates rise. That is reflected in a rising yield and a falling price. Bond investors hate inflation!

Shares are traditionally a much better home for your money in a modestly inflationary environment. That’s particularly true if, as now, inflation is the consequence of rising demand rather than a supply shock such as the oil price hikes in the 1970s.

Companies can pay a higher dividend if their profits rise which provides some protection to investors. They can also raise their prices if demand allows, securing the profits out of which they pay their dividend.

Only when inflation rises to historically high levels can it also cause a problem for investors in shares.

As well as bonds and shares, a well-diversified portfolio will hold other assets, some of which also have a good track record of hedging against moderate levels of inflation. These include infrastructure (where income streams can sometimes have an explicit inflation link), real estate (where rents can rise in a strong economy) and commodities, including gold.

How we plan for it

One last point about inflation. For years, we have not had to worry too much about rising prices when planning for the future. However, if inflation does return, our calculations about how much money we will need to save for a comfortable future may need to adapt.

To take that 4% inflation example once again. If you think it is prudent to take 4% out of your savings pot each year to live on, you might need an 8% investment return to allow you to do that while still maintaining the real value of your portfolio over time. That may not be realistic, particularly when looking into the future from today’s relatively high valuations.

Looking through the other end of the telescope, if you thought a retirement pot of £500,000 would be sufficient for your needs, in a higher inflation environment you might need £750,000. Which might mean saving more or working longer, or a combination of the two.

Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Tax treatment on ISAs and SIPPs depends on individual circumstances and all tax rules may change in the future. The minimum age you can normally access your pension savings is currently 55, and is due to rise to 57 on 6 April 2028, unless you have a lower protected pension age. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to a Fidelity adviser or an authorised financial adviser of your choice.

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