It’s been more than two years since inflation reached a 40-year high of 11.1% in October 2022, but the latest data shows that it’s creeping back up again.
Despite briefly returning to the Bank of England’s (BoE) 2% target in 2024, inflation stayed above this level for 9 of the 12 months in the year. And, according to the latest data from the Office for National Statistics (ONS), inflation rose by 3% in the 12 months to January, reaching its highest level in 10 months.
High inflation can be detrimental to both your personal finances and the wider economy, with cash savings being particularly vulnerable.
Read on to discover the risks of holding too much cash amid persistently high inflation.
Inflation can reduce the “purchasing power” of your cash over time
If the interest rate on your cash savings fails to match or exceed inflation, the real value – or “purchasing power” – of your money will gradually decline.
For instance, if you deposited £10,000 in a savings account earning 2% interest while inflation averaged 3% over the year, your balance would grow, but its purchasing power would shrink. By year-end, you’d have £10,200, but to maintain the same real value as before, you would need £10,300. So, you’d have made a real-terms loss due to inflation.
Over time, this gradual erosion can significantly reduce the purchasing power of your savings, even if the balance appears to be increasing.
The graph below shows how different inflation rates (2%, 3%, and 5%) can diminish the purchasing power of £10,000 in cash savings over a 20-year period.
Source: Quilters
As you can see, even with a modest 3% inflation rate, the real value of your savings could shrink by nearly half (£4,463) over 20 years. Even at the BoE’s 2% target rate, your purchasing power could still decline by around a third (£3,270).
So, with inflation having recently been persistently above optimum levels, there’s a strong chance that your cash savings will lose real value over time.
Investment returns typically have a better chance than cash of outpacing inflation over longer time horizons
While it’s a good idea to hold onto some cash savings for your short-term goals as they offer easy access to liquid funds, the market has historically offered better chances for outpacing inflation.
The graph below shows the percentage of time that large-cap stocks and cash outpaced inflation in the US across various time horizons from 1923 to 2023.
Source: Schroders
As you can see, over a single month, cash and stocks had a similar probability of outpacing inflation. However, over longer periods, the odds shifted significantly.
The likelihood of stocks outperforming inflation increased consistently, reaching 100% over a 20-year horizon. In contrast, cash became less likely to beat inflation over a decade but slightly improved to a 65% success rate over 20 years.
While holding some savings in cash can be beneficial, investing in stocks offers greater potential for long-term wealth growth and inflation-resistant returns.
The market can’t guarantee security, but there are strategies you can adopt to protect your investments
Beyond guaranteed returns, a key advantage of keeping cash savings is the protection offered by most accounts under the Financial Services Compensation Scheme (FSCS), currently up to £85,000.
While the market doesn’t guarantee returns or protection, history demonstrates its strong long-term growth. By adopting the following investment strategies, you can enhance stability and improve your chances of success.
Diversify your portfolio
Portfolio diversification means spreading investments across different asset classes, sectors, and regions.
A well-diversified portfolio reduces the impact of downturns in any single area while increasing your exposure to wider growth opportunities.
Additionally, diversifying across asset classes can help preserve wealth against inflation, as gains from appreciating investments may offset the declining purchasing power of cash holdings.
Focus on long-term growth rather than short-term trends
Maintaining a long-term focus and not reacting to short-term volatility allows you to capitalise on the market’s trend toward growth. Furthermore, as you read earlier, the market has historically had a higher likelihood of outpacing inflation as more time passes.
Research from Schroders highlights the risks of exiting the market during downturns. For instance, investors who pulled out during the 2008 financial crisis would likely still be recouping their losses, whereas those who stayed invested saw their portfolios rebound by around 2013.
Even after major declines, the market has historically recovered faster than waiting for equivalent returns from cash. So, focusing on long-term market growth rather than short-term fluctuations is often a better route to success.
Speak to a financial planner
A financial planner can help you develop and adopt strategies to ensure your wealth keeps up with inflation.
They can assist in building a well-diversified portfolio, keep you focused on long-term goals during market fluctuations, and adjust your strategy as needed to ensure you stay on track.
To speak to a financial planner, get in touch.
Email us at hello@vwmwealth.com or call us on 0141 229 4004.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
All information is correct at the time of writing and is subject to change in the future.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
