Inflation, Cash and the Purpose of Investing

The words ‘rising costs of living’ and ‘Inflation’ have crept back into the headlines again. Here we look at what impact inflation may have over time, whether investing can protect against inflation and how much we should hold in cash when investing.

“Inflation is an economic term that refers to an environment of generally rising prices of goods and services within a particular economy. As general prices rise, the purchasing power of consumers decreases. Commonly, people may refer to inflation as ‘the rising cost of living’”

The most immediate and notable effect of inflation returning is an increase in monthly food and fuel bills. Our pounds don’t go as far as they used to even six months ago. Less obvious is the way inflation can erode savings. For example, £10,000 in a zero-interest bank account may still have a value of £10,000 in 5, 10, 25 years’ time but their purchasing power reduces at the rate of inflation every year. In terms of purchasing power, after 25 years of 2.5% inflation that £10,000 becomes the equivalent of £5,450.

Put another way, if cash reserves yield 2.5% less than the rate of inflation, then their purchasing power could nearly halve over 25 years, which would not seem like an attractive investment, or even a ‘safe’ one. The purpose of investing, therefore, is usually to ensure that money grows at, or above, the longer-term rate of inflation.

The current and projected costs of inflation are built into everything we do on behalf of our clients, including longer-term financial planning and cash flow and investment portfolio construction and implementation. The goal is to ensure that the right balance is invested in real assets such as Shares, Index Linked Gilts and Property which in turn should increase the chances of achieving a real return in excess of inflation over the longer-term (typically meaning ten years or more).

All the return assumptions we make are above inflation, whatever inflation may be. We are very conservative when building long term financial plans. Being conservative enables us to ensure that financial plans have a better chance of succeeding. For example, we currently expect our Moderate 60 model portfolio to grow by 2.1% above inflation after all fees. This is much lower than the actual growth of 3.9% above inflation since 1970. This covers a period when the Retail Price Index (RPI) averaged 5.6% between 1970-2020, peaking at 12.5% in both 1981 and 1982. This compares to the last 30 years where the RPI averaged 3.1% from 1990-2020. These historical records show that a having sufficient investments in real assets should help to protect an investor from inflation in the long term. (Source: Dimensional Matrix Book 2021)

Although investing is a sensible method of mitigating inflation risk, thereby providing for longer-term financial security, investing too much can leave investors in a vulnerable financial situation. Investments can be volatile over the shorter-term, rising and falling in value. Therefore, keeping an appropriate amount of cash is essential to provide for shorter-term financial security before investing. Quantifying and maintaining the correct amount of cash is an important part of the planning process to give investors the capacity to tolerate such shorter-term losses in the pursuit of potentially higher longer-term gains.

How much should be kept in cash?

Apart from income, everyone needs a shorter-term cash reserve to cover both predicted and unpredictable costs in the foreseeable future. The amount is different for each person and family and is dictated by individual circumstance and levels of expenditure, security of income and whether they are accumulating capital or withdrawing an income from capital. It is down to how each person chooses to live their life and what is prudent but also what they would be willing to forgo if markets go through a bad patch.

It is useful to think of the term ‘expenditure’ in different categories:

  1. Essential Expenditure – The necessary level of expenditure to sustain oneself (rent/mortgage, utilities, food and drink, clothing, etc).
  2. Lifestyle Expenditure – The level of expenditure needed to maintain a chosen lifestyle. This will vary from person to person, but it is essentially the desired quality of life to be maintained.  This might include eating out, one holiday a year, hobbies, Christmas and birthday presents.
  3. Discretionary Expenditure – This is the aspirational level of expenditure that could be foregone in extreme market conditions (to allow investment withdrawals to be suspended and income reinvested).  This might include other holidays or luxury holidays or travel, substantial regular gifts, or more expensive hobbies.
  4. Capital Expenditure – This refers to any foreseen capital expenditure within the next five years, meaning expenditure that might otherwise require investment capital to be drawn.  This might include a new car, home maintenance or improvement or substantial one-off gifts (perhaps a wedding).

Some may be prepared to reduce some of the last 3 categories of expenditure if they lose their job or if the market falls. As such, they may be comfortable holding lower levels of cash reserves and investing more of their funds.  Others may not be willing or able to make such compromises.  As such, they may feel more comfortable holding a higher level of cash and investing less.  This can therefore be a very personal decision.

In our next newsletter we will cover in more detail how we apply a robust framework in establishing and reviewing suitable levels of cash reserves for our clients.

If you would like to  discuss the level of cash reserves appropriate to your circumstances further, please speak to your adviser.

This article was produced for educational purposes and aimed at UK residents. Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

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