This is a question I am asked almost daily, especially by those with cash on deposit in banks earning historically low levels of interest.
With inflation at elevated levels, the poor returns on offer by the banks are not just disappointing – they can be very damaging to the purchasing power of your money.
To illustrate just how damaging the effects of inflation can be, imagine we have a pot of £2m. If inflation is 2%, the pot would be worth £1,135,000 in 20 years’ time. With inflation at 5% over the same period, the pot is worth £717,000.
These levels of inflation might seem a distant concern, but the Bank of England expects inflation to reach 7% by spring 2022, and inflation remains at high levels across many developed countries.
What is the purpose of holding cash?
The main purpose of holding cash is for daily spending and as an emergency reserve that you can dip into at little or no notice. As such, there is not much else you can do but just accept the frustratingly low returns.
A financial planning rule of thumb is to hold at least 6 months of expenses in cash and this is in addition to any planned purchases. However, with the current uncertainty around Covid, there is an argument of increasing this to 12 months. Of course, this has to be determined on an individual basis but it is a good place to start planning.
For the cash that you do retain on deposit in the bank, give thought to:
- where it is held – avoid blacklisted jurisdictions where any interest might be taxed at a punitive rate
- level of protection – for example, the compensation scheme in Jersey, Guernsey and the Isle of Man is £55,000 compared with £85,000 in the UK and €100,000 in the EU. This is per person and per institution, so ensure you are spreading your cash amongst unconnected banks
- currency – if possible, try and match the currency of deposit with your expenditure to minimise currency conversion risk
How to protect against inflation
With any cash in excess of your set spending period and emergency fund, you should consider purchasing or holding assets that have demonstrated the ability to act as a hedge against inflation. These tend to be equities and commodities, specifically gold.
Equities are traditionally seen as an inflation hedge because they represent ownership of physical capital whose value is assumed to be independent of inflation i.e. a company can offset rising input costs by simply charging more for their product or service.
Commodities are basic goods or raw materials that are treated equally, irrespective of who produced them, for example, sugar, copper, coal, gold. Commodity prices usually rise when inflation does, so they are seen as good protection against inflation.
Gold, a commodity itself, has been a shelter during times of crisis for centuries as it is physical and has generally held its value. As such, it is often considered a hedge against inflation and can even be seen as an ‘alternative currency’, particularly in countries where the native currency is losing value.
Having said the above, investing raises a related issue which is that assets that protect against inflation typically come with more volatility. This means that you must ensure you carefully consider and monitor risk, are properly diversified and are investing in an appropriate manner for your circumstances. If you are not an experienced investor, it is best to seek qualified advice.
How we structure investment portfolios?
We can help clients create well-diversified investment portfolios to meet their financial goals that are appropriate for their circumstances.
Simply put, we can assist with advising on:
- Where to invest – choosing the right jurisdiction to hold your wealth for tax efficiency and security
- How to structure your investment – selecting the right investment vehicle for your needs
- Who to invest with – choosing the right financial institution(s) to entrust with your money
- What you should be investing in – building an investment portfolio to meet your needs and preferences e.g. income, growth, ethical considerations, currency choices, risk mitigation, proper diversification
The above article was kindly provided by Mark Quinn from The Spectrum IFA Group and originally posted at: https://www.spectrum-ifa.com/how-do-i-make-my-cash-work-harder/