Peace of Mind – but at what cost?
“It’s the feeling of just knowing it’s there, isn’t it? I like that I can access it at any time.”
These two statements are something we hear often when discussing excess cash holdings with clients. It can be ingrained into us as individuals to think that cash is the best option; it won’t go down, we can access it at any time, and we’ll know the rate of return we are earning in the form of interest. Nice and simple.
But let’s examine that first statement a little closer. Because whilst it is correct to say that generally cash holdings won’t go down, they will, more often than not, lose value. Savings we have now will likely be worth less in a few years’ time.
It sounds obvious doesn’t it? We all know that inflation makes goods and services more expensive over time. But, do we really stop to consider its effects, to look at it in more detail?
At its core, inflation is one of the most powerful and yet most subtle destroyers of wealth over time. We don’t see it happen, we rarely hear about it or consider it, yet its effects cannot be ignored.
It’s best illustrated by running through some examples:
Say I had £10,000 sitting in the bank, earning 1% interest. All well and good, but inflation as of July 2019, is currently 2%. So therefore, I am losing 1% per annum, or in this case £100. Assuming this continues over five years, my original £10,000 is now worth £9,500. I’ve therefore paid, albeit unknowingly, around £100 a year to retain that aforementioned ‘peace of mind’.
The numbers are more concerning over a longer time scale. Using the Bank of England inflation calculator, we can see that the average inflation rate from 1988 to 2018 was 3.3%. Therefore, for me to have the equivalent of £10,000 in 1988 I would need a whopping £26,341 in 2018!*
The interest rates offered by banks or building societies will rarely match the relevant rate of inflation. We are in danger of losing real value year-on-year if we are retaining excess cash. So, what are the solutions?
Well, we could tie money up for a period of time in a cash-based savings account, also called a term-deposit. For us to agree to lock our money up for a set period of time, we quite rightly expect to be compensated in the form of a higher interest payment. In these sorts of accounts we might be closer to matching inflation. However, the negative is we have very little flexibility in the event inflation or interest rates rise whilst we are ‘locked-in’.
Another idea is to consider investing excess cash. At this point, I would state that any investment into the stock market should only be considered if you can afford to invest for a minimum of five years, and the funds are not essential to your standard of living. I am talking about long-term savings, over and above your day-to-day spending and your emergency account.
The stock market, or a blend of different investments, can offer a fantastic guard against inflation. To go one step further, it can generate returns well in excess of inflation over the long-term. As an example, the average annualised rate of return on the S&P 500 index (assuming dividends are reinvested) is around 10% compared to the average US inflation rate of approx. 3%.**
I would caveat the above by saying that stock market values are volatile in the short-term and will go down as well as up. But it is that very volatility that is the price of those extra long-term returns, and therefore extra wealth.
You should only invest in full knowledge of the risks and after receiving appropriate independent financial advice.
Guarding against inflation should form part of your financial planning strategy. Having a plan in place will help you achieve your personal goals, whether it be control over when you retire, helping your children buy a property or simply providing that long-term ‘peace of mind’.
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*Bank of England Inflation Calculator: https://www.bankofengland.co.uk/monetary-policy/inflation/inflation-calculator
**Dimensional Fund Advisers: https://us.dimensional.com/perspectives/the-uncommon-average