Keeping cash in the bank could be more risky that investing it in shares… but what about keeping up with inflation?
Many believe that investing is risky and that it is safer to keep your money in the bank. This may be true in the short term since the value of stocks can go down as well as up, whereas the amount of money deposited with the bank should not decrease.
But does that mean that it is less risky in the long term?
Perhaps not. Over time inflation can have a significant impact on the purchasing power of money and you will miss out on the positive power of compounding. Consider £1,000 held in a chequing account today. What would happen if you kept the money in the bank for the next 30 years? Well, the purchasing power of your money would reduce significantly.
The below chart shows the change in purchasing power of £1,000, assuming a 5% inflation rate.
Although you would still have £1,000 in 30 years’ time it would be worth just over £200 in today’s terms! Admittedly 5% inflation may seem like a lot given today’s economic conditions in developed markets but don’t forget UK inflation was above 20% in the late 1970s and close to 10% in the late 1980s!
There are of course many reasons to keep some cash in the bank. These include liquidity, emergency funds and short-term savings (for example to pay for a new car in 3 months’ time). If you’re allocating your money for the medium to long term, it may be worth putting your money to work.
How to protect yourself against inflation
So how can you protect against loss of purchasing power? Well, one way of doing so is to invest the money. For example, you could purchase a portfolio of shares or even invest in a medium term fixed deposit with your bank (assuming you can receive an annual interest rate in excess of expected inflation). Although these investments carry a degree of risk, the higher expected returns should more than compensate for this in the medium to long term.
Investing in stocks might be more volatile in the short term, but they will most likely continue to grow in excess of inflation over time…and this is exactly what you need, especially if you want it to fund your lifestyle in the future!