Inflation, Cash and the Purpose of Investing

After over a decade of reasonably stable inflation, it has once again shot back into the headlines. Not only are prices increasing across the board, but essentials like essentials like food, fuel and energy are experiencing some of the biggest increases, hurting the bottom line of many households. The treasury’s decision to freeze personal tax and pension allowances provides a squeeze from the other side. This squeeze will only get more severe as the years go on, especially if inflation remains high. For those who are fortunate enough to be able to save, or who have a significant reserve of cash already, it is becoming more important to protect against the effects of inflation. 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.

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. Many people see saving into a bank account as a sensible way to protect their money for the future. However, interest rates have long been far less than inflation. This means that money sitting in a bank account is actually losing value. For example, £10,000 in a zero-interest bank account may still have a nominal 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. This does 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. This includes 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. These include Shares, Index Linked Gilts and Property. Getting this balance right should increase the chances of achieving a real return in excess of inflation over the longer-term (typically meaning ten years or more).

As a firm, 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. It even peaked 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)

Investing is a sensible method of mitigating inflation risk, thereby providing for longer-term financial security. However, investing too much can leave investors in a vulnerable financial situation. Investments can be volatile over the shorter-term, falling, as well as rising, in value. Therefore, keeping an appropriate amount of cash is essential to provide for shorter-term financial security before investing. Keeping enough in cash means not have to use investments to sustain oneself when the market has crashed. Taking money when the market is low means having to sell a bigger proportion of investments to get the same amount of money. This can put anyone’s longer term financial prospects in jeopardy.

Quantifying and maintaining the correct amount of cash is an important part of the planning process. It gives investors the capacity to tolerate such shorter-term losses in the pursuit of potentially higher longer-term gains. Click the button below to learn more about how much you should hold in cash when investing.

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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