The big risks of holding too much in cash

It can be reassuring to know exactly how much money you have and that it is secure, which is what cash savings accounts provide.

However, while cash savings are useful for short-term expenses or emergency funds, relying on them for long-term financial goals may not be the best approach.

Over time, cash tends to struggle against inflation compared to other investments, which could limit the growth of your wealth and hinder your ability to meet your long-term objectives.

Despite this, there is currently an estimated £1.4 trillion sitting in “lazy” accounts, accruing little to no interest and struggling to keep up with inflation.

Read on to discover the risks of holding too much in cash accounts and why market investments may be a more effective strategy for growing your wealth over the long term.

Inflation erodes the purchasing power of cash over time

Unless the interest on your savings account consistently exceeds the rate of inflation, the real spending power of your savings will diminish over time.

For instance, if last year you saved £1,000 in an account that offered 1% interest on your savings and inflation averaged 2%, your savings would have grown but lost real-terms value.

By the close of the year, your account would have returned £10, so your cash would be worth £1,010. However, the cash would need to be worth £1,020 to maintain the purchasing power it had the year before, due to the effects of inflation.

Over long periods, this can eat into the value of your wealth and leave you considerably worse off than you were before, in real terms.

The graph below shows how inflation of 2%, 3%, and 5% can reduce the value of cash over 20 years.

Source: Quilters

As you can see, the real value of your wealth could drop by nearly half over that period if inflation averaged just 3%.

This highlights the importance of exploring investment options that offer the potential for higher returns and better protection against inflation over the long term.             

Investing typically gives you a better chance of outpacing inflation over longer time horizons

Cash savings can be a good place to save for shorter-term goals, such as building an emergency fund. However, over longer time horizons, investing in the market has typically given your cash more potential to beat inflation.

The graph below shows the percentage of different periods where large cap stocks and cash have beaten inflation in the US between 1923 and 2023.

Source: Schroders

As you can see, over a single month, the chances of your cash or stocks beating inflation are around the same.

Yet, as time progresses, the chances of stocks beating inflation steadily rise, reaching 100% after 20 years. Conversely, cash becomes less likely to outpace inflation over a decade, though it increases its chances slightly over a 20-year period to 65%.

So, while keeping some cash savings could be wise, investing in shares offers a greater potential for your wealth to grow and outperform inflation over time.

Savings accounts provide security, but there are also effective strategies to safeguard your investments

Two key benefits of keeping your cash in savings accounts are the ease of access to liquid funds, and the assurance that your money is protected (up to the Financial Services Compensation Scheme limit).

As you read earlier, having access to some liquid funds can be useful. However, while savings accounts may be secure, they leave your cash open to the eroding effect of inflation.

Although the market may never be able to guarantee returns on your investment, historically it has delivered, and there are certain strategies you can adopt to help ensure you build a balanced and stable portfolio.

For instance, portfolio diversification is among the most effective strategies for safeguarding your investments.

By diversifying your investments across different asset classes, sectors, and geographic regions, you mitigate the impact of a downturn in any single area. This approach spreads risk across a range of holdings that are unlikely to all decline simultaneously.

Another effective method of helping to ensure long-term stability and financial security is to remain patient and resilient amid market dips and fluctuations.

Research by Schroders reveals that converting investments into cash during historical market downturns would have been detrimental in the long run.

For instance, investors who liquidated in 1929 at the onset of the Great Depression would have had to wait until 1963 to break even, whereas those who remained invested recovered by 1945.

Similarly, those who exited the market during the 2008 financial crisis would still be waiting to break even today, while those who stayed invested had recovered by around 2013.

The difference in recovery times between staying invested and liquidating occurs because cash typically yields lower returns compared to investments.

So, while cash savings offer a degree of security, the market has historically provided stronger returns that are more likely to beat inflation.

Get in touch

A financial planner can help you determine how much of your wealth you may need to be liquid and how much you can invest.

To find out more about the long-term value of investing in the market and the effects of inflation on your cash, get in touch.

Email info@mlpwealth.co.uk or call us on 020 8296 1799.

Please note

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.