The risks of holding cash

The annual rate of inflation, at 10.1 per cent in January 2023 (1), is far higher than the highest interest rates you can receive on a current account, which stood at 3.03 per cent at the time of writing (2).

On this basis, the buying power of cash is at present dwindling by approximately 7 per cent a year. This is because cash is increasing by around 3 per cent a year, but the value of that cash (what you can actually buy with it) is falling by around 10 per cent a year. The 7 per cent erosion of purchasing power represents the difference between the two.

To put it more concretely, the 10.1 per cent rate of inflation suggests that a supermarket shop which cost £100.00 in January 2022 would cost £110.10 in January 2023 (you can find an explanation of how inflation works in our ‘How inflation is calculated’ article).

Meanwhile, if you held £100 in a current account during the same 12-month period, it would now be worth around £103 at today’s interest rates. So, if you wanted to use these cash savings to pay for the same supermarket shop, then you would have to find around £7 from somewhere else in order to reach the required £110.10.

In short, rising inflation has left you around 7 per cent less well off, as £7 is 7 per cent of the value of your original £100.00. In precise mathematical terms, your money would actually buy you 7.4 per cent less with each passing year. So your real return on the current account is -7.4 per cent.

Real versus nominal values

What you are left with is a nominal increase in cash from £100 to around £103 between January 2022 and January 2023. But in real terms (i.e. in terms of spending power), the value of the initial £100 fell to around £93 between January 2022 and January 2023.

Chart 1 shows how the real value of cash would dwindle if the 7.4 per cent annual decline were to continue into the future.

Chart 1: The real impact of inflation on cash

Source: Schroders Personal Wealth, February 2023. Past performance is not a reliable indicator of future results.

The chart looks at the real value of £100,000 held in the current account offering the highest interest rates, which at the time of writing is a 3.03 per cent rate. Chart 1 shows that, over ten years, cash held in this current account would lose more than half of its value in real terms. Over 15 years it would lose more than two-thirds of its value and, over 25 years, it would lose more than 85 per cent of its value in real terms.

In 2048, at the end of the 25-year period, cash held in the current account would amount to £210,908 – its nominal value – based on 3.03 per cent interest rates. But its real value to a cash investor in 2023 terms would be £14,726.

If we now revert to our supermarket shop comparison, by 2048 your £100 in a current account would have grown to £210.91. But it would only be able to buy £14.73-worth of goods in the shopping trolley in 2023 terms. A quick review of a well-known supermarket website shows that this would enable you to buy a 4-pack of baked beans, a bottle of tomato ketchup, 1kg of carrots, 300g of chicken breasts, a box of cereal, a box of teabags, a loaf of bread, some milk, some butter and some pears. Not much for a weekly family shop…

Chart 1 is for illustrative purposes only, as we expect inflation to fall in the long term. Even so, Chart 1 does illustrate the real impact on cash if inflation and interest rates were to remain at current levels.

Highest inflation for decades

However, inflation in recent months has reached heights not seen for decades (3). But Chart 2 shows that in the 20 years to January 2023 a cash investor would have seen their cash returns outpaced by inflation. The inflation line shows the accumulating impact of inflation since January 2003.

Chart 2 shows that the value of cash declined in real terms during the period, as, from 2017 onwards, the total returns on cash fell below the accumulating impact of inflation. But interest rates were at unprecedentedly low levels for much of this time, as central banks cut interest rates following the 2008 Global Financial Crisis. So this was an unusually challenging period for cash investors.

Chart 2: How a medium-risk portfolio has performed against cash and inflation

Source: FactSet, Schroders Personal Wealth, SONIA Overnight, Consumer Prices Index, MSCI World index (total returns in sterling), Bloomberg Global Aggregate Bonds index (total returns in sterling). Cash is represented by SONIA Overnight rates; inflation is represented by the Consumer Prices Index (CPI). SONIA refers to the Sterling Overnight Index Average and it reflects the average interest rates banks pay to borrow sterling overnight from other financial institutions. At the time of writing it stood at 3.93 per cent (4). Past performance is not a reliable indicator of future results.

Perhaps more significantly, Chart 2 shows a medium-risk portfolio, comprising 60 per cent global equity assets (shares) and 40 per cent global bonds, significantly outpaced both cash and inflation in the 20 years to January 2023. This portfolio of broad-based assets is based on a 60 per cent allocation to the MSCI World index of global equity assets and a 40 per cent allocation to the Bloomberg Global Aggregate Bonds index, which, unsurprisingly, contains global fixed income.

The MSCI World index’s largest geographical allocation is to the US stock market: US shares comprised 67.7 per cent of the index at 31 January 2023. But it also has around 6 per cent in Japanese shares and around 4 per cent each in the UK and Canadian stock markets. Its highest allocation in terms of industry sectors is to information technology, at 20.7 per cent, followed by financials at 14.5 per cent and healthcare at 13.5 per cent (5).

The Bloomberg Global Aggregate Bonds index has a 55.7 per cent allocation to government bonds, with significant holdings in US Treasury bills and Japanese government bonds. It also holds around 16 per cent in corporate bonds and around 12 per cent in mortgage backed securities (6).

These indices are well spread across different shares and bonds, which reduces investment risk by not being too concentrated in any one area.

Chart 2 shows the performance of a simply constructed medium-risk portfolio of stock market and bond market investments. In our view, it indicates the potential benefits of investing for the long term in a diversified portfolio of assets. It also highlights some of the potential risks to investors of holding cash. At Schroders Personal Wealth (SPW) we can hold a wide variety of asset types in addition to equity assets and fixed income.

Popular financial biases

Unfortunately, research suggests that many of us tend to view our income and wealth in nominal rather than real terms, an effect known as ‘money illusion’ (7). This means we can overestimate the future buying power of cash savings because we are not fully taking into account the impact of inflation. Research also suggests we tend to underestimate the future potential values of stock market equity assets, an effect known as ‘exponential growth bias’ (8).

Looking again at Chart 2, the fact that the medium-risk portfolio has performed relatively strongly in the past does not mean it will do so in the future. But it does draw attention to a key risk of holding cash for the long term, that investors could miss out on strong potential returns from other assets such as shares and fixed income.

It can be daunting to try and work out which investments may be suitable for you in the current high inflation environment. If you are concerned about your investments, then please remember that a financial adviser is well placed to provide the support you need.

Sources

(1) ons.gov.uk, ‘Consumer price inflation, UK: January 2023’, 15 February 2023.

(2) moneyfacts.co.uk, ‘Best high interest current accounts’, 15 February 2023.

(3) Financial Times, ‘UK inflation accelerates to 41-year high of 11.1%’, 16 November 2022.

(4) ycharts.com, ‘Sterling Overnight Index Average (SONIA)’, 17 February 2023.

(5) MSCI, MSCI World Index (USD) factsheet, 31 January 2023.

(6) SPDR Bloomberg Global Aggregate Bond UCITS ETF factsheet, 31 January 2023.

(7) Darriet, E., Guille, M., Vergnaud, J.C., and Shimizu, M. (2020), ‘Money illusion, financial literacy and numeracy: experimental evidence’, Journal of Economic Psychology, 76, 102211; Cohen, R.B., Polk, C., & Vuolteenaho, T. (2005), ‘Money illusion in the stock market: the Modigliani-Cohn hypothesis’, The Quarterly Journal of Economics, 120 (2), 639-668; Shafir, E., Diamond, P., and Tversky, A. (1997), ‘Money illusion’, The Quarterly Journal of Economics, 112 (2), 341-374.

(8) Levy, M., and Tasoff, J. (2016), ‘Exponential-Growth Bias and Lifecycle Consumption’, Journal of the European Economic Association, 14 (3), 545–583; Almenberg, J., and Gerdes C. (2012), ‘Exponential growth bias and financial literacy’, Applied Economics Letters, 19 (17), 1693-1696; Stango, V. and Zinman, J. (2009), ‘Exponential Growth Bias and Household Finance’, The Journal of Finance, 64: 2807-2849.