Blog: Cash is not king – how inflation erodes savings



Bruce Swankie

Bruce Swankie, Financial Adviser at Brewin Dolphin Aberdeen warns against hoarding cash

 

There’s something reassuring about money in the bank. It’s easily accessible; stowed away in a trusted institution; and, when you make a withdrawal, it’s tangible. No wonder then that in times of uncertainty people tend to favour cash, believing it will protect their savings.

By contrast, investors often only feel comfortable investing in stocks, shares, and funds when the outlook feels relatively certain. As Brexit draws closer and signs of fragility emerge in the world economy, such as Turkey’s recent troubles, it could be tempting to stockpile cash in the bank.

Unfortunately, there’s no such thing as risk-free investing – even if you do place your money in a bank account – and the simple reason for that is inflation.

Inflation quantifies the increase or decrease in the cost of living, measured by movements in the consumer price index. Generally speaking, it’s given comparatively little attention, despite its clear impact on your shopping basket.

You won’t see the effects of inflation published on your bank statement, for instance. All you see is your cash and any interest gained, which doesn’t make any adjustment for what the balance is worth in real terms.

Yet, the effects of inflation can be damaging, gradually eroding the value of your money. A more accurate bank statement would illustrate how much you have ‘lost’ through the decline in your savings’ purchasing power.

To take an example, let’s say you had £10,000 in cash 10 years ago. According to our research, the actual return on that figure, taking inflation into account, has averaged negative 1.80% per year over the past decade.

Even removing the effects of tax, that’s the equivalent of losing £180 annually at the outset. And, after 10 years, the total losses in terms of spending power would have totalled £1,663. You’re then left with a cash sum with a real value of just £8,337 – a 17% decline.

This is because inflation has pushed up the cost of goods and services in the real world while the interest paid on your cash has failed to keep up. And, of course, any tax you need to pay on your interest would reduce the returns still further.

The Office for National Statistics recently announced that inflation had risen for the first time since November 2017, to 2.5% in July. If it stays at that level for a decade, it would turn £10,000 today to the equivalent of just £7,763.30, reducing the value of your money by almost a quarter.

With inflation far outpacing the Bank of England’s base interest rate of 0.75%, savers are losing money every day. There are numerous ways of protecting against the erosive effects of inflation, but none have been as consistent as investing in stocks and shares.

Naturally, even in the most cautious portfolio there is a risk to capital and, if stock markets fall, you could end up with less than you put in. But, investing in equities should be viewed as a five-year commitment at the very least, which increases the likelihood of a positive return after inflation.

Broadly speaking, the opposite is true with cash: the longer it is in the bank, the more likely you are to have a negative real return because of inflation. In fact, over the past 10 years after-inflation returns on shares have outperformed the equivalent on cash by 74%.

Money in the bank may feel safe in times of uncertainty – more than £200 billion languishing in cash ISAs suggests a lot of people follow that mantra. But, in reality, it’s merely eroding savings and people’s purchasing power.