Inflation

Post 3 of 7

Savings held in cash may not be volatile, but they are not risk free.

Many investors believe that cash is an unexciting but safe investment, based on the traditional method of monitoring investment risk, in terms of volatility of return. In other words, an investment which fluctuates widely in value is higher risk than one which will maintain its value consistently. Cash appears to be the lowest risk asset.

Whilst this has been the foundation for a large amount of financial theory, common sense dictates that an asset which holds its value in nominal terms may not be such a great investment under inflationary conditions. An apparently conservative approach in portfolio management might allocate too much to cash and ignore the erosion of purchasing power by inflation.

To illustrate this point we set out a table which shows the erosion of purchasing power of a £10,000 lump sum over various time periods, at different rates of inflation. For simplicity and reflecting current reality we assume no interest income. At the extreme end of the illustration, using 15% inflation over 25 years, the value of a £10,000 lump sum has been eroded to £304. Whilst the Bank of England is targeting 2% inflation, over 25 years this is still sufficient to reduce purchasing power by 39%. The effect may in fact be greater than this assumes, as retail price inflation does not reflect inflation in a number of categories which are more relevant to high net worth individuals, such as healthcare or education expenses, that typically rise at faster rates.

graph6

We recognise the diversification role and the opportunity benefit of holding cash in a portfolio, i.e. to be able to take advantage of market volatility to buy assets cheaply, but these charts also illustrate that allocating too much to cash in an environment where inflation takes hold could be described as ‘reckless conservatism’.
 
This paper is prepared by Optimus Capital LLP and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. This document contains general information only and is not intended to represent general or specific investment or professional advice. The information does not take into account any individual’s financial circumstances or goals. An assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial or other professional adviser before making an investment decision. Investment involves risks to both capital values and to levels of income received. Past performance is no guide to future results, and you may not receive back all the money invested.

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