We all like to have some cash put aside for a rainy day, but if you have more than you reasonably need to meet most contingencies you really need to think about investing the surplus.

With inflation running high you need to get more from your money than simply leaving it sitting in cash. Inflation will eat away at the spending power of this money, but you can fight back by putting the cash in the markets.

Deciding where to invest can be daunting. The answer is finding shares or funds with the ability to generate enough income and capital gains to offset the impact of rising prices.

THE OPTIONS

UK inflation is already at 7% and is certain to go higher in the coming months as the spike in fuel costs from the Ukraine crisis coincides with the lifting of the price cap on household energy bills.

The Bank of England estimates consumer prices could rise by 8% by the end of April, yet in parts of Europe inflation is already approaching double figures.

When inflation rises it reduces the real value of cash, meaning your spending power goes down.

If you want to protect your savings from being eroded by rising inflation, there aren’t many options available to you.

If you put your cash in a savings account you will be lucky to earn 1% interest, especially as the base rate is just 0.75% for now. One exception is app-only bank Chase which has launched a savings account paying 1.5%, though to qualify you must also open a Chase current account.

If you put your money into 10-year UK government bonds, you could earn a yield of around 1.5% before tax. The yield is set by the market, and functions as the inverse of the bond price.

If yields go up it is because the price of the bonds has gone down, which means your bonds are worth less than you paid for them.

The first rule of making money is not to lose money. You can’t afford to lose capital if you want to protect yourself from inflation.

In the past, gold has been a popular place for people to put money when inflation has taken off, but for small investors it isn’t straightforward, and in this cycle, gold hasn’t really lived up to its billing.

Also, gold doesn’t generate any income or pay any interest, so you are 100% reliant on the price going up and not losing any of your capital.

STOCKS ARE THE ANSWER

When you buy a share in a company, you effectively get a ‘share’ of its earnings.

Rather than the company dividing up any profit each year and sending a cheque to its investors, you make money if the value of your shares increase to reflect the company growing its earnings and/or from any dividend payments which it might choose to make.

If you invest in a fund or investment trust, the same principles apply. They invest in companies or other assets like bonds. If the underlying value of their portfolio increases, so too should the value of the fund units or shares. And if the underlying portfolio generates an income for the fund or investment trust, they will typically pass on some or all that money as dividends to you.

HOW MUCH COULD I MAKE EACH YEAR?

The Barclays Equity Gilt Study charts the annual ‘real’ returns of different UK assets over each decade, meaning they are adjusted for inflation. Equity is another term for stocks and shares and a gilt is a UK government bond.

On average, from 1920 to 2020 shares have generated a return over inflation of 6.4% per year whereas UK government bonds have generated a return of 3% above inflation.

The average excess return on cash over the same period was 1.4%, which means investing in UK stocks generated well over four times the returns which cash savers could have hoped to achieve.

It’s worth pointing out that these figures relate to a period that includes the Great Crash of 1929, the Second World War, the oil crisis of the early 1970s, the bursting of the tech bubble and the global financial crisis.

Stocks didn’t go up in a straight line, in fact far from it, and anyone who invests in shares must accept there will be good years and bad years.

Yet in every 10-year period, equities produced a positive return over inflation, unlike UK government bonds or cash.

The secret is to stay invested through the ups and downs, resist the temptation to sell when things get rocky, and most importantly resist the temptation to try to time the market.

LOOK FOR TOTAL RETURN

There are two ways to make money in stocks: capital appreciation (the value of your shares or fund units goes up) and dividends, and ideally you want to look for shares or funds that offer both.

Over the long run, most of the excess returns from equities have come from reinvesting dividends, that is using the money the company pays you to buy more shares.

This has the effect of compounding your returns, so that each year you own more shares, which means you get a higher dividend and you can buy even more shares to add to your investment.

With funds you can buy an ‘accumulation’ version which effectively reinvests dividends for you. They work by increasing the value of the fund units rather than automatically using the dividend money to buy more units.

It’s also worth mentioning that companies themselves can buy back their equity, which means there are fewer shares in circulation, increasing the value of those which are left.

ARE SHARE BUYBACKS POPULAR?

According to AJ Bell’s investment director Russ Mould, so far in 2022 nearly a third of the companies in the FTSE 100 large-cap index have announced share buybacks.

The total amount of cash FTSE 100 companies have this year set aside to buy back their shares is nearly £33 billion, more than in the whole of last year and close to the all-time record of £34.9 billion in 2018, and we are only just over three months into 2022.

When combined with the £80 billion of dividends which analysts expect companies in the FTSE 100 to pay out this year, it implies the index could generate a 5.4% return simply from buybacks and dividends, excluding any change to the value of the shares in the index.

THE LOW-RISK APPROACH

Before you start looking for places to put your money you need to decide how much risk you want to take on.

Bear in mind the reason shares outperform government bonds is because investors need to be compensated for the extra risk in equities compared with the safety of a government guarantee.

Not all stocks carry the same risks, however, and buying individual stocks isn’t advisable if you want to minimise your risk.

A fund, investment trust or exchange-traded fund (also known as an ETF) with an emphasis on income might be a better avenue, although not many come with a yield which can match the 7% inflation rate.

The Association of Investment Companies’ website allows you to screen all the investment trusts in the equity income sector by various criteria including dividend yield.

One trust which comes close to paying a 7% dividend (5.87%) is Aberdeen Standard Equity Income (ASEI).

It invests mostly in large companies such as BP (BP.), Shell (SHEL) and Rio Tinto (RIO), and trades at a small discount to the value of its assets.

The ongoing charge is 0.89%, which means the net yield is just under 5%, and assuming you own shares through a tax wrapper such an ISA then you will pay no tax on dividends and capital gains.

REITs, a term to describe real estate investment trusts, also tend to offer good yields. Many REITS trade at a premium to the value of their assets because investors are willing to pay up for secure long-term income.

Healthcare REITs typically trade at a premium to net asset value and have relatively high ongoing fees, while many logistics REITs now trade at double-digit premiums to NAV.

Commercial property REITs which own a mixture of real estate assets are less highly rated and offer both attractive yields and the potential for capital gains.

For example, Alternative Income REIT (RGL), which manages a £70 million portfolio of assets, currently yields 7.1% and trades at an 11% discount to NAV. Its properties include hotels, retail parks, gyms, care homes and a petrol station. Ongoing fees are on the higher side at 1.27%.

OPTIONS FOR INDIVIDUAL STOCKS

If you decide you want to invest directly in individual companies to beat inflation then you need to look for a combination of attractive yields, cheap valuations and share buybacks.

A quick screen of the FTSE 350 index of stocks using research platform SharePad throws up quite a few companies which might tick the box for investors wanting inflation protection and upside share price potential through a mixture of low valuations and share repurchases.

Housebuilders are both cheap and have high yields, and questions over the size of their liabilities for fixing cladding on high-rise buildings look as though they have been answered with something called the ‘Building Safety Pledge’.

Most housebuilders have already put aside provisions for the work, yet their market values have dropped significantly as investors have been worried that the final bill could spiral upwards.

For example, Persimmon (PSN), which yields 11% at today’s price, believes its remediation costs are roughly £75 million while its market capitalisation has tumbled by £1.9 billion since early January.

Also weighing on housebuilders’ share prices have been concerns that rising interest rates make mortgages more expensive and potentially stop a greater number of people from getting on the housing ladder.

The rising cost of living has also clouded the ability for some people to save enough money for a property deposit. These issues combined have led some commentators to suggest the UK property market may weaken later this year.

Investors therefore need to weigh up these risks when looking at housebuilders, and not simply buy the shares because they pay generous dividends. That said, one could also make the argument that so much bad news has already been priced into the sector.

Miners Rio Tinto and Glencore (GLEN) are both yielding over 10%, while tobacco companies British American Tobacco (BATS) and Imperial Brands (IMB) also have inflation-beating yields and the former is buying back £2 billion of its shares which is a positive tailwind for investors.

Several financial firms are paying generous dividends combined with share buybacks, such as Aviva (AV.), Direct Line (DLG) and M&G (MNG).

Finally, mobile phone group Vodafone (VOD) is paying a dividend in line with inflation and is currently buying back £1.2 billion of its shares.

DANGER ZONE

If inflation keeps rising as it is forecast to, you might be tempted to go for higher-risk investments such as cryptocurrencies, but that might be a bad move.

Cryptocurrencies don’t generate any income and don’t pay dividends, so you are totally reliant on the price going up to protect you from inflation.

Proponents claim cryptocurrencies are a diversifier and their returns have nothing to do with the stock market, but they are almost pure risk and when markets get the jitters money could easily flow straight out of them.

Markets can be volatile at the best of times, and you never know when the next crisis might appear. Nobody had a global pandemic on their list of market risks for 2020, for example.

Therefore if you want to put your spare cash to work in the markets, we would stick to funds with an attractive income, reasonable fees and preferably a discount to NAV, or well-known, established FTSE 350 stocks which offer inflation-beating yields.

Disclaimer: AJ Bell owns Shares magazine. The author (Ian Conway) and editor (Daniel Coatsworth) own shares in AJ Bell.

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