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Why cash isn’t king when inflation reigns

26 July 2021

7 minute read

Holding on to cash can have its benefits. It provides liquidity and diversification in your portfolio. And you always need to keep some to hand to deal with life’s emergencies.

Yet hoarding substantial amounts over a long period can be a drag on performance as inflation erodes its real value over time.

And with inflation accelerating at its fastest pace in decades as the global economy rebounds out of the COVID-19 crisis, it could be time to reduce that cash pile.

A sensible first step could be to work out how much of your cash is not being deployed so you can position your portfolio for stronger inflation. After all, your assets always have to beat inflation to make a ‘real’ return.

Some experts are split on how much further inflation can rise – and for how long. Barclays Private Bank, for one, believes that the current high inflation is temporary and will wane over time.

Yet, waiting for inflation to return to more ‘normal’ levels is no reason to sit on piles of cash.

Misplaced reasons for holding cash reserves

It’s also worth considering whether you’re holding cash for financial reasons or psychological ones.

Holding a small proportion of your cash usually has merit for diversification purposes, or to deploy tactically when a short-term opportunity arises.

However, the reality is, market timing rarely works. If it did, everyone would be doing it and getting rich. Similarly, fleeing to cash during turbulent markets can also be a bad move. It’s nearly impossible to know when to get back into the market. And cash can end up on the sidelines for much longer than an investor anticipates – potentially giving up substantial gains.

Missing out on opportunities

You also need to think what your cash could be worth if you had done something different with it. This is often referred to as your ‘opportunity cost’.

As the chart below shows, equities and bonds have both historically outperformed cash, albeit past performance is not a guarantee of future returns.

The true cost of holding cash

Many investors hold cash because in the short term they have a fear of losses, which is understandable. But holding cash over the long term may lead to a loss as inflation erodes the value of the capital. This cost typically becomes larger the longer the holding period or the higher inflation is.

The table below shows how inflation of just 1.05% each year would erode the value of $10m over time – and the investment return needed to regain the lost value and maintain the purchasing power of the capital.

Infaltion erodes cash over time
Time Erosion of value Balance ($) Return required to regain purchasing power
Initial amount - 10,000,000  
2 years -2% 9,791,103 5%
5 years -5% 9,485,910 12%
10 years -10% 8,998,249 26%
25 years -23% 7,680,597 80%

It’s worth noting that the above table is based on an annual inflation rate of just 1.05% and doesn’t factor in any interest your cash may earn sitting in a savings or money market account.

Yet, today’s inflation rate is much higher – depending on the yardstick you use to measure it – allied to the current ultra-low interest rate environment. In the US, the consumer prices index is rising at an annual rate of 5%1, its highest pace since August 2008. While the Bank of England is forecasting UK inflation to top 3% before the end of 20212. It means rising prices will take an ever-larger chunk out of the purchasing power of your cash.

Rethinking cash

Holding cash can seem like a passive choice. You’re not investing your money, after all. So, you give it less attention than you would your other investments.

But you shouldn’t think of it like that. For an investor already in the markets, it should be viewed as an active choice to be in cash – just like equities or bonds.

Instead, cash should be part of your diversified investment portfolio with some additional ‘dry powder’ on hand to deploy when an attractive investment opportunity arises.

People like to think of cash as ‘king’, but in reality it can be very costly. Being passive and sitting on your cash will ultimately see your portfolio disappoint. And these lost opportunity costs will only widen in times of higher inflation.

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