Key takeaways:

• Higher inflation leads to a greater loss of purchasing power

• Where interest on cash savings lags inflation, real returns are negative   

• There is an opportunity cost - both positive and negative - to holding cash 

With inflation currently at multi-decade highs, leading to higher prices across the board, it a good time to think about what your money is doing for you. 

Is it worth putting money in the bank as interest rates rise, or does it make more sense to put spare money into the stock market? In considering this question, one needs to understand that while the inherent value of a dollar remains the same, inflation may erode the spending power of that money - in other words, money loses value over time.

With that in mind, let consider how the two options stack up.

Inflation and its Impact on Purchasing Power

While holding some emergency' cash for unforeseen circumstances is a prudent move, it may be a different story if you are talking about all your savings.

The reason for this stems simply from the loss of purchasing power that occurs with inflation. 

Inflation is the phenomenon where rising prices reduce consumers' purchasing power. For the same product or service, consumers pay more than before. Alternatively, consumers pay the same amount as before for less goods. This decrease in purchasing power is measured across a basket of goods and services throughout the economy.

Now more than ever, a loss in purchasing power is particularly important as we move through one of the worst inflationary environments in decades. Much of this was fuelled by a significant increase in money supply after governments around the world printed money at an unprecedented rate in response to the pandemic and lockdowns.

Even though interest rates are now rising sharply in an effort to bring down inflation, there is a lag for this to take effect. In the meantime, for as long as there is a disparity between savings rates and inflation, purchasing power continues to slip, despite the value of said money remaining unchanged. 

The Reserve Bank of Australia has warned that 15% of bank accounts pay zero interest, while more broadly, banks are being scrutinised for not passing on the full magnitude of rate hikes to savers.

There is some thought that once inflation starts to approach the RBA benchmark target, the central bank may be inclined to shift monetary policy from a restrictive setting back to an accommodative stance. 

Therefore, even though it may seem like savings rates would be higher once inflation cools, rate cuts would likely flow through to savers as well. Regardless, the central bank sees inflation running above target for another two years.

Understanding Opportunity Cost

If a loss in purchasing power is just one potential risk factor associated with holding cash during an inflationary environment, the other issue that needs to be considered is opportunity cost.

This economics principle relates to the loss of other alternatives when one alternative is chosen. In other words, by choosing to invest in cash and generating a fixed return, investors forgo the alternative of investing in the stock market, where returns can be much higher - and also, where negative returns are possible.

On this front, every investor will have their own views on whether the risk-return tradeoff is appropriate for them. It may depend on their age, goals, lifestyle needs, assets, and a host of other personal circumstances. Nonetheless, over the long-term, the stock market is considered one of the most successful asset classes to invest in.

Despite the ups and downs, the stock market tends to go up over time. With this, investors need to have a long-term mindset. By investing in the stock market, volatility and negative returns will be encountered from time to time. 

That means there will be specific periods where cash outperforms the stock market, even if it is a case of minimising one losses. However, across a long-term horizon, stock market returns have proven more rewarding for investors. Do remember, past performance is no indicator of future performance, but history does offer interesting insights. 

Investors should ask themselves whether it is an efficient means of wealth creation to store all their surplus funds in cash, and to the contrary, whether it is too risky to store all their funds in the stock market. 

It is worth remembering, inflation erodes the value of money, and savers incur real losses when savings rates are below inflation - that without taking into account tax payable on interest as well.   

Cash has a particular importance for those looking to preserve capital, whether it be due to their circumstances or short periods of extreme market volatility, but the opportunity cost associated with being in the stock market - both positive and negative - should be considered as an alternative.

Final Thoughts

For investors, everything really needs to be considered in the context of one investment horizon. The majority of investors will be looking at a long-term timeframe. Historically, the long-term performance of the stock market has shown favourable returns compared with most other assets, particularly cash, where an opportunity cost has emerged.

Cash may have its place when things get turbulent, or where investors need to prioritise stability in lieu of returns, but an environment where savings rates fail to keep up with inflation effectively locks in negative real returns for cash.