What is inflation and why do we need to protect against inflation eating into our savings?
When we save money we would, at the very least, like to protect its value.
In other words, we don’t want to access our savings at a later date only to find that they have lost value, or that they can now buy less goods or services than they could have done at the beginning.
For this reason, a natural human reaction is to look for a savings vehicle that is very safe, with zero (or very little) likelihood of loss. For example, people will typically put money in a cash product, such as a basic savings account at a bank.
Unfortunately, instead of eliminating the risk of loss, this approach will almost certainly result in one.
But how can this be? Shouldn’t our cash be safe in a bank account?
Well, the problem is inflation.
What do we mean by inflation? You can think of inflation as the general increase in the price of goods or services within an economy. Since inflation, in developed economies (such as the U.K. or the U.S.), typically runs at 2-3% per annum, this means that over time the same goods or services usually become more expensive.
This clearly creates a problem for savings. If our savings don’t keep up with this rate of inflation, then even if our savings are growing in nominal terms (i.e., growing in pounds and pence), then they will still be falling in value in real terms (after adjusting for inflation).
So when we save money for future use, instead of simply seeking to avoid a nominal loss, we should really look to protect its value in real terms. In other words we would like our savings to, at least, match the rate of inflation.
In an ideal world, we would also like our savings to achieve some real growth (savings growing faster than inflation) that will allow us to buy more goods and services than if we were to have simply spent the money in the first place.
However, in order to have a good chance of achieving this we usually need to look beyond only investing in cash products.
Now this isn’t to say that there is no place for cash [see: cash]. There are several benefits to cash:
- We can be sure that, over time, its purchasing power will largely be preserved, which adds some stability to a portfolio;
- Cash is a highly liquid asset which can be accessed very quickly (e.g., in an emergency);
- Having some cash within an investment portfolio provides some flexibility to take advantage of market opportunities that may present themselves [caveat: the perils of market timing / dollar cost averaging]
However, unless we are going to need to access all of our savings in the very short-term, then there is a very compelling case for exploring other asset classes. [See: magic of compounding]