How to invest in a high interest rate environment

The Bank of England has held rates at 5.25% since August 2023, but cash savings rates have been coming down since last summer. One option to try to make your money work harder is to consider investing it. Here’s how you can invest to try and beat UK inflation.

Some top paying savings accounts will offer you more than 5% interest at the moment – but there are plenty that are offering rates below the current rate of inflation of 2%. It’s always worth shopping around so that your money isn’t effectively losing value.

Another way for your nest egg to consistently grow faster than the soaring cost of living, could be to invest it. But there are things you need to consider first. You need to remember that investing is for the long term and your capital is at risk.

In this article, we explain:

• What are some of the reasons that people choose to invest?
• How do I diversify to try to reduce volatility?
• What are some of the benefits of investing small, regular amounts?
• How do I keep my returns tax-free?

Read more: How to invest £10,000

Why do some people invest their money?

History suggests that investing in assets such as shares has been a reliable way to grow your savings faster than inflation over the long term. However, over the short term, and depending on what you invest in, things are a lot less consistent.

The average annual return for the FTSE 100, for example, was 7.3% over the past 30 years (assuming dividends are reinvested). That comfortably outstrips the 2.1% average annual growth in inflation over the same period, according to the wealth manager New World Financial Group.

Investing is something almost anyone can do, even if they start with only a few pounds. You can choose your own mix of assets through an online investment platform (although you should always consider getting independent financial advice).

You could also opt for a ready-made fund. Here you choose your preferred level of risk, this is how comfortable you are – or not – to take a more risky approach in the pursuit of higher returns. The platform will then package up a selection of funds that it thinks will suit this risk profile.

If you’re nervous about going at it alone, read more here about the typical cost of financial advice.

Below are our investment tips to help people try and stay on top of inflation.

How do I diversify to try to reduce volatility?

Gold, UK equities and residential property were assets that beat inflation in the year to the end of March 2022, according to Becky O’Connor from the investment platform Interactive Investor.

But she said that it is impossible to predict whether all or any of them will continue to do well, as past performance is no guarantee of future results.

She recommended having a diverse portfolio with a mix of assets, including equities, property, less risky bets such as bonds, and alternative asset classes such as gold.

This way you will not be overexposed to the fluctuating fortunes of particular assets, firms or sectors.

For new investors or those who favour a hands-off approach, one of the best ways to diversify is with an investment fund. These hold shares in many firms, perhaps focusing on a certain sector or country.

Popular examples include:

• Fundsmith Equity
• Legal & General’s Global Technology Index
• Vanguard’s US Equity Index

If you want even more diversification, there are funds that invest in a wide range of assets, countries and sectors, including:

• Vanguard’s LifeStrategy range
• HSBC Global Strategy portfolios
• BlackRock’s MyMap portfolios

Think long-term

Financial advisers typically recommend investing in shares for at least five years to boost your chances of enjoying the sort of returns that financial markets can deliver.

“Stocks tend to be volatile over shorter periods, which makes them a riskier investment than some other asset classes,” said Lisa Tipton from New World Financial Group.

If you need the money in the short term, the risk is that the market might just go down before you had planned to cash in your investment.

Stock markets went through varying degrees of turbulence in 2022, but there has been recovery since.

At the end of December 2023, the FTSE 100 was up almost 5% compared to the start of the year. So far in 2024, it has risen by almost 11%.

Drip-feed your money in

A way to smooth out losses in uncertain times is to drip-feed your money into the markets – a process known as pound-cost averaging.

By investing small amounts at regular intervals you will sometimes invest when the market is high, getting fewer shares for your money, but you will sometimes  invest when it is low, meaning you will get more.

This is likely to smooth out the ups and downs of the market compared with investing a lump sum in one go, which could suddenly plummet in value if you bought just before a crash.

The counter argument is that the smaller your investment the smaller your gain if markets soar. But in the long run the aim is to reduce volatility and end up with higher returns overall.

Watch below our guide to steady investing.

Keeping some cash savings

While the interest rates on most cash savings accounts are low compared with inflation, it is important to set money aside for emergencies, such as losing your job or a broken boiler.

If you were to keep it all in investments, such as shares, you might be forced to cash them in when the markets are down meaning you could lose money.

It is often recommended that you have enough cash to cover at least six months of essential outgoings.

To protect this against inflation as much as possible, find the highest-paying savings account.

Make use of tax wrappers

Investing in an Isa means that any returns you make will be tax-free.

You can pay in £20,000 each tax year across one or a number of Isa products – whether that’s stocks and shares, innovative finance, cash or a lifetime Isa (depending on your age). Read our guide to the best stocks and shares Isas.

If you are saving for retirement, a pension may be a better option. Any income you save into your pension is free of income tax.

This will happen automatically if you are a member of a workplace scheme. But if you put money into a private pension, this is regarded as coming from your after-tax pay. Your provider will apply to the government to top up your contributions with the tax relief.

For example, if you put in £80 as a taxpayer on the basic rate of 20%, then £100 goes into your pension pot.

This is limited to the basic tax rate of 20%. If you are a higher-rate or top-rate taxpayer paying into a private pension you can claim a further 20% or 25% respectively via a self-assessment tax return.

Tax treatment depends on your individual circumstances and may be subject to future change. The content of this article is provided for information purposes only. It is not intended to be, nor does it constitute, any form of tax advice.

Five funds to consider buying at a time of high inflation:

Emma Wall, head of investment analysis and research at investment platform Hargreaves Lansdown, suggests investors consider the five funds below.

• BlackRock Gold & General mainly invests in gold-mining companies across the globe. But it also invests a small portion of the fund in companies mining other commodities, such as silver or diamonds.
• HICL Infrastructure Company invests in high-quality infrastructure that plays a significant role in the well-being of communities, such as schools and hospitals. It helps to drive sustainable income for investors over time. 
• Troy Trojan invests in a mix of stocks, bonds, gold and cash with the aim of beating the RPI inflation. The fund favours large, established companies that can grow sustainably over the long run and get through tough economic conditions.
• Artemis Income focuses on companies that can maintain and even grow dividend payments to investors despite inflation or other events in the wider economy. Investors who don’t require the income there and then can reinvest the dividends to boost longer-term growth.
• JO Hambro UK Equity Income invests in businesses of all sizes, with a third of its portfolio made up of finance companies.

‘The banks will never beat inflation’

Marianna Hunt, 27, is investing any money she sets aside each month with the ultimate goal of buying a property at some point in the future. 

“The main reason I invest my savings, rather than putting them in a cash savings account, is because I know the banks will never increase their interest rates as fast as inflation. In the long term, I’m confident investing will provide better returns,” she said.

Although Marianna may be correct about the banks not being able to beat inflation long term, investing in stocks and shares puts your capital at risk.

All investments carry a varying degree of risk and it’s important you understand the nature of these. The value of your investments can go down as well as up and you may get back less than you put in.

Marianna, who works in communications, started investing three years ago. She contributes a regular sum each month to both a lifetime Isa and a stocks and shares Isa.

About 90% of her money is invested in a mixture of funds, with the remaining 10% in individual companies. Her funds include

• Baillie Gifford Positive Change
• Baillie Gifford China
• Liontrust Sustainable Future Global Growth
• Vanguard Global Small-Cap Index

Her individual stocks are Microsoft and OneSavings Bank.

Marianna said: “My investments were all doing really well until the Ukraine conflict, rising inflation and higher interest rates hit the stock market. My investments are currently up 5% from when I started three years ago, but last year they were up 45% at their peak.

“I’m holding my nerve and plan to invest my way through it. I have some cash savings equivalent to six months of outgoings. This is to cover me for any emergencies but I see no reason to have other cash savings. With investing, your money can fluctuate a lot – but it’s better than losing value to inflation.”