The liquidity crisis that taught my seven-year-old about compound interest

It started as a domestic liquidity crisis and quickly became a lesson in behavioural economics led by a seven-year-old.

I had to pay the cleaner and was £10 short. After exhausting the usual places – old coat pockets and handbags – I remembered my son’s money box. I’m proud to say he’s a saver.

“Can Mummy borrow £10?” I asked, smiling.

“No!” came the truculent response.

“I’ll pay you back tomorrow.”

“No!”

“What if I pay you back £10 and £1 interest?”

I was then challenged to explain interest and the wonders of compounding. I didn’t go as far as to point out that at an interest rate of 10% a day his £10 would be worth 13 thousand trillion pounds (or 13 quadrillion) in a year. But, having secured my strict promise to repay him the next day, he was smart enough to recognise a good deal.

Growing in confidence, I ventured to suggest he put the rest of his money in the bank. He said he didn’t trust banks.

Leap of faith

Given the news on banks this year, maybe he had a point. But his comment set me thinking. Investing anywhere requires several leaps of trust. This trust is a crucial underpinning of the financial system and one my seven-year-old has yet to develop.

The first leap is to trust our governments to responsibly manage the value of fiat money – the pound that used to be in our purses and wallets. If long bond yields are the litmus test, the Bank of England appears to be just about credibly preserving its value against inflation with the highest rates of interest for 15 years¹. That makes cash a sensible first step into the world of formal investing.

Around 75%² of the UK’s 13 million ISA account subscribers have their money in cash ISAs. That’s about £56bn². National Savings & Investments (NS&I), a UK state-owned bank, currently offers 6.2%³ gross for a year, but I bet the bulk of that ISA money is generating much less. Lag inflation by just 2% a year and £100 will be worth just £80 in real terms by the time my son is 18.

And money box savers? Sorry, son, but if inflation remains unchanged, you’re looking at your £100 spending power shrinking to just £45 by the time you can order your first alcoholic drink.

The Bank of England has a calculator that shows the real-terms impact of inflation on your cash, going back to the Middle Ages.

The next step

If my son has no faith in banks, central or private, then how will he react when I introduce him to the concept of shares? Over the long term this is the asset most likely to match or outpace inflation and deliver real growth, yet his mistrust is not unusual.

For a fund manager who invests in shares, this raises serious questions. How do we persuade sceptical savers to entrust our profession with more of their money in inflationary times?

In theory, shares should help to hedge against inflation. You’re buying a stake in a company and a share of the profit it makes. Let's say this company has lots of factories. In times of inflation the value of those factories should go up. Choose the company well and it will have little debt and pricing power (the ability to pass on costs to the end customer without causing them to switch to a competing product) so it can counterbalance the rising cost of materials and wages. As a result, share prices rise.

Testing the theory

That’s the theory. How can I persuade my son it works in practice? I might point him towards Turkey. Its current inflation rate year-on-year is more than 50%⁴. In the past 12 months the Borsa Istanbul 100 index of pretty much the biggest hundred Turkish companies is up nearly 150% in lira terms and a respectable 70% in US dollars⁵.

My father is Iranian. He knows something about crises. He’ll tell you that when serious inflation strikes, it’s time to invest in real assets such as gold and even cars. Shares may not be as tangible an asset, but the market rise demonstrates that Turks see them as a viable avenue for protecting the value of their wealth.

There are other reasons why shares have worked in Turkey. Real rates are still deeply negative and holdings of that other haven asset, the US dollar, are heavily regulated. Generally, when there is runaway inflation and broader economic mismanagement in a country, a good company on low valuations is still not enough to tempt in an international investor in company shares.

Pricing power

But the point still stands, the pricing power of a company such as Coca-Cola İçecek, the main distributor in Turkey, has allowed it to put through triple-digit price increases so far this year. The parent Coca-Cola in the US has also managed an inflation-busting 9% this year. No matter what the environment, Coca-Cola has demonstrated phenomenal ability to navigate such pressures.

Investors have choices, and a sensibly diversified investor may pick bonds and shares. So why do so many sit in cash?

I suspect the simple answer is that they underestimate the impact of inflation on their wealth and overstate the risk of losses, particularly from shares, over the long term. Yes, inflation creates challenges for companies in the short term, particularly those that are indebted, because central bankers will lift interest rates and deliberately suppress demand to tame it.

The solution

For me, the solution is to avoid economically sensitive companies with high borrowings and look for those that have pricing power, especially now when valuations have little potential to reward us for taking more of this type of risk.

Even good companies may be squeezed, but over time they tend to recover lost ground.

Of course, we can point to the data and teach sensible investment practice, but my conversation with my son underlines that investing for the long term ultimately requires faith.

That’s why, as a parent, I must try to ensure a positive experience of investing – the same job, it transpires, that I have as an investment manager.