Saving for the future is something we should all be doing. It helps us to afford life’s major outlays such as homes, holidays, cars, weddings, university and retirement. But many of us are making a huge mistake by keeping too much of our hard-earned money in cash, and for too long.
The problem with cash savings
The interest rates offered by banks are so low that our savings are never going to really increase in value. Keeping cash under the bed or stuffed down the sofa offers even worse returns, without the security. But the real danger comes from inflation, which has the power to destroy the value of our cash savings, even in the short term. Just look at this table and then read on to see how I reached these astonishing figures.
|
Holding period (years) |
£10,000 in cash |
£10,000 in UK stocks |
|
1 |
£9,743.00 |
£10,550.00 |
|
5 |
£8,779.00 |
£13,069.00 |
|
10 |
£7,707.00 |
£17,081.00 |
|
20 |
£5,940.00 |
£29,177.00 |
|
30 |
£4,579.00 |
£49,839.00 |
|
40 |
£3,529.00 |
£85,133.00 |
|
50 |
£2,720.00 |
£145,419.00 |
The table above shows the impact of inflation on the value of our cash savings, assuming an inflation rate of 2.57% over the period (historical UK average over the last 30 years) and interest rates staying as they are.
Inflation reduces the purchasing power of an amount of money by increasing the cost of goods and services. In just five years, inflation could reduce the real value of £10,000 in cash by a startling £1,221, or in other words 12%. While the value after 30 years would be less than half of what it was at the beginning.
This illustrates that with such poor interest rates currently on offer, we really can’t afford to be keeping any more money in cash, than is absolutely necessary. This is typically thought to be enough to cover six months of living expenses, in case of emergencies.
So what should we do with the rest?
The table also shows the value of £10,000 invested in the stock market over the same time horizon, assuming a return after inflation of 5.5% (the average return of UK stocks over the last 50 years).
While inflation could reduce the value of your cash by 65% over 40 years, investing in shares could increase the value by over 700%.
The takeaway is clear. Instead of leaving our money in cash at the bank, we should endeavour, where possible, to invest it in the stock market. The gulf in value becomes much larger the longer the investment period, due to the compounding of stock returns. This can have huge implications for our wealth over our lifetimes.
Even if money is needed only a couple of years in the future, we should still invest it, rather than keep it in cash. But we should then be taking less risk, than we would when investing for the long term, and we should diversify properly too. This means index trackers, FTSE 100 large-caps, big dividend payers and bonds. If we are saving for the long term then we have more leeway in terms of risk, but to be honest I’d stick to a similar approach for best results.
