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Why holding cash can seriously damage your wealth

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Friday October 29, 2010 at 10:00am
In business cash is king. As accountants we talk about it all the time: what is cash flow like? who owes you money, how can you conserve your cash etc. But when it comes to personal finances and investment strategies the opposite is generally true.

Cash is seen as risk free as there’s a perception that it cannot fall in value. Research by Finametrica (specialists in risk profiling) estimates that we are twice as concerned about losing money as we are about seeing an increasing return on our investments. Hence many people hold cash simply because they believe it won’t fall in value.

But there is risk in cash – and that’s inflation, and ignoring this risk could be an expensive mistake. Bank base rates are currently 0.5% however Retail Price Inflation is running at 4.6% and Consumer Price Inflation (government’s preferred measure as it is more comparable with European measures and excludes mortgage rates, council tax and other housing costs) is running at 3.1%.

By holding cash you are seeing a reduction in the real purchasing power of your money. With a gap between inflation and the return you receive on cash of say 3% your wealth is actually falling in real value each year by 3%, meaning you will be able to buy 3% less with your money next year than you can this year.

If you invest in cash for 10 years, at a rate 3% below inflation your wealth will be able to purchase 27% less than it can today. Over 15 years it will lose 37% of its value. An investment that loses over 25% in 10 years is not exactly safe.

So what is the alternative? You don’t have to go for high risk investments to try and maximise the return, the sensible thing is often to go for low risk investments that keep pace with inflation.

If we use volatility as a measure of risk (being the amount by which an investment deviates from its average value over time) then clearly cash is low risk and exhibits low volatility. The only problem with cash is the inflation risk. There are plenty of investments that provide an income that is higher than the rate of inflation but have a low volatility, not as low as cash, but then they are at least keeping pace with inflation and so producing a real return.

The moral? Don’t let fear rule your personal investment strategies. Look at all the options and consider the risks and volatility of each. By holding a spread of such investments you can decrease the risk of losses if one particular investment is downgraded.

Andy Parker
Chartered Financial Planner, Birmingham

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Parker Chartered Accountants and Financial Advisors is the trading name for Parker Business Development Ltd (Registered No. 4116664), Parker Tax and Trust Ltd (Registered No. 06950353) and Parker Financial Planning LLP (Registered No. OC347027). Parker Financial Planning LLP is authorised and regulated by the Financial Conduct Authority. All companies are registered in England and Wales – registered office contact details here