Should you save or invest when interest rates are higher?

Understandably, lots of people wonder whether to save or invest their money. The best interest rates available on cash have been rising with the Bank of England base rate over the past couple of years. From a low of 0.1% across most of 2020 and 2021, there was a steep trajectory higher over 2022 and 2023 to above 5% in 2024 as the bank has battled to keep a lid on the spiralling cost of living.

From here, it’s widely expected rates will drop away, starting later this year, as inflation comes under control and starts moving decisively towards the Bank’s target level of 2%. For savers it is something of a reprieve.

For years cash paid next to nothing, especially in relation to rising prices, but now there are some competitive Cash ISAs and savings accounts paying between 4% and 5%. That’s if savers shop around. Sadly there are plenty of products, especially legacy ones, paying poor rates.

If you feel daunted about chasing the best deals, a cash savings platform could help you. These offer deposit rates from a selection of smaller and “digital” banks, and building societies who are all competing for savers’ cash by offering better returns. Depending on your near-term plans a mix of easy-access, fixed-term, and notice accounts can provide both flexibility and better returns.

Even competitive rates on cash can trail the rate of rising prices over the longer term. So, what can you do to beat inflation? Providing you have a good cash buffer to cover unexpected costs, and you are willing to take a long-term view, investing is well worth considering.

Saving money vs investing: the lowdown

Investing works best over the long term

When you buy shares, you are buying small slices of companies and stand to get a share of growth and increasing profits. That’s why over the long-term investing wisely can significantly increase your wealth over time.

There are risks, especially in the shorter term. Profits don't always go up and companies can shrink as well as grow. In addition, the stock market rises and falls depending on people's confidence in the economy and in businesses, which can lead to investments losing value. It’s therefore necessary to think long term, invest in a range of assets to spread the risk and only commit an amount you aren’t going to need for at least five years.

Diversification helps you manage investment risk

What is higher risk in the short term can be far less so in the long run. A well-managed and diversified portfolio gives you the prospect of decent long-term returns that can drive your wealth forwards rather than backwards in relation to the cost of living. In fact, saving too much in cash could be more damaging to your financial position over long periods than taking risks with investments, especially if you are not maximising the interest available on cash with competitive products.

Global stock market returns (red) versus inflation (grey) and cash (pink) over past 20 years

Source: FE fund info, total return basis in pounds with income reinvested; stock market returns represented by the MSCI World Index, inflation by the UK Consumer Price Index and cash by Bank of England base rate; data to 31/03/2024

Cash savings in an ISA can offer security

Understandably, lots of people ask themselves “should I save or invest?” The relentless rise of inflation over time can hinder those keeping large sums in cash from attracting good interest rates. By holding too much in cash, investors risk not making the most of their money – or falling short of their financial goals. Unlike cash, riskier assets do not offer the security of capital, but over the long term they tend to do better and build wealth more effectively.

Yet everyone needs a buffer against uncertainty. How much of a buffer you need will probably come down to how uncertain your life is. One rule of thumb is keeping about six months of essential spending as cash to be called upon as and when needed. However, much will depend on circumstances such as type of employment, family arrangements and whether you rent or own your home. You may want a bit more for extra peace of mind.

Having a separate ‘rainy day’ fund in savings can help you feel more confident when you spend, and the assurance that you won’t need to touch money invested for longer-term goals. Overall, it’s about striking the right balance and having a plan you’re comfortable with. If you are not sure how best to do this then it may be worth speaking with one of our financial professionals to help you understand your current situation and give you a clear plan tailored to meet your needs.

Cash ISAs offer tax free interest – but keep an eye on your personal allowance

Cash ISAs can be a good home for cash as any interest is tax free. Take care to select the right account for your circumstances, though. If you need instant access then avoid fixed rate accounts where your money is locked up for a specified period.

Bear in mind, too, that the personal savings allowance means some of the interest you receive from normal bank and building society accounts (along with any fixed interest investments) is tax free anyway. The allowance is as follows:

• Basic-rate (20%) taxpayers: £1,000
• Higher-rate (40%) taxpayers: £500
• Additional-rate (45%) taxpayers: £0 – i.e. no allowance.

The personal savings allowance is on top of the income tax personal allowance, so if you're a non-taxpayer – that is you have less than £12,570 income per year – then even more interest on cash can be tax free without using an ISA.

It is therefore worth considering whether your ISA allowance might be better used for assets that generate a higher level of return and might therefore mean a higher tax burden over time.

Prioritising ISAs for riskier areas can often make sense. Fortunately, ISAs are highly flexible and you can transfer from a Cash to a Stocks and Shares ISA, and vice versa, without losing the tax-free status, so if your situation changes you can adapt your ISA to suit. Find out more about UK tax brackets here.

Why do people not invest?

For some it can be really daunting taking the plunge into investment products like a Stocks and Shares ISA, especially when the world seems so unpredictable. Concerns about risk, unfamiliar financial jargon, or feeling unsure about which investment fund to choose can discourage some of us from taking that step at all. Our own research into the ‘investment gap’ uncovered the main reasons why people do not invest – which we dubbed the “The Four C’s”.

Getting an understanding of these four challenges can help you make your money work harder toward your financial goals, whether you’re investing for the first time or saving money for something special.

1. Confusion over risk and reward

All investments can fall as well as rise, and worries about performance is a common deterrent for would-be investors. Our research revealed that two in five (40%) of people are concerned about market volatility and felt investing was just too risky.

Gaining more understanding with investing can help, especially around the important principles of time and diversification. Time is generally an investor’s friend and is particularly beneficial in terms of mitigating risks. Invest for one day and the chances of a positive return are pretty much 50/50 but invest in global stock markets for 10 years and studies have shown the odds rise to over 90%. This is based on historic data, so it must be pointed out that the future may not be like the past.

Meanwhile, diversification, spreading your money across lots of different investments, helps reduce idiosyncratic risks. Not being reliant on one or a small number of company shares, or one sector or geographical area, is sensible. Ideally, various investments making up a portfolio should be ‘uncorrelated’ with each other, in other words, they are affected by different sets of risks so are less likely to move up and down in tandem.

2. Choice

We suggest new investors use funds rather than shares in order to spread investment – and risk – across dozens of different companies. However, with thousands of these available, where do you start when trying to pick one? More knowledgeable investors can use our Preferred List to help narrow down the field and inform their choices. It’s created and updated by the Charles Stanley research department to highlight what we consider to be good-quality options in each of the major areas for new investment.

Alternatively, if you want a ready-made diversified portfolio of investments and don’t know where to start take a look at our Charles Stanley multi-asset funds, which offer an expertly picked selection of investments and are tuned to a given return objective and level of risk.

Please note investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus and understanding the risks involved.

3. Complexity

There is also a perception that investing is complicated. It certainly can be an in-depth process if you are going to commit to researching and selecting individual company shares for example. A fifth of people say they find keeping on top of the data too challenging.

Yet there are also several straightforward, low-maintenance ways to invest – and they can be very effective. Keeping it simple when it comes to investing could mean a ‘tracker fund’ that aims to replicate the performance of a market through owning all or most of the companies in it. A global tracker, for instance, will cover a large proportion of all the companies in the world.

Meanwhile, multi-asset funds such as one in our own range can offer a handy way to access a professionally-managed, diverse portfolio covering lots of different areas – equities, bonds and other areas – in a single investment.

4. Communication

Off-putting financial jargon is probably the biggest barrier of all. Well, over half (55%) of the people we questioned weren’t confident they understood financial terms, and this was particularly true among women. For instance, we found that only 20% of people understood the term ‘equities’, for instance, and the term ‘shares’ to explain investing in individual companies is better understood. To help break down the jargon check out the simple explanations of investment terms and concepts on our YouTube channel.