With high returns on cash deposits, why risk money in private markets?

Burning money
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Ziad Mabsout
August 15, 2023
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Cash savers are currently reaping the benefits of the highest returns seen in almost two decades, with some accounts offering interest rates exceeding 5%. As a result, individuals are increasingly turning to cash individual savings accounts ("ISAs"), committing more funds than in the past five years. However, the impact of inflation on the real value of savings must not be overlooked, prompting investors to explore alternative opportunities to optimize their returns.

While cash provides certainty in its nominal value - £100 today will remain £100 inthe future, its spending power is not guaranteed. Low inflation may help sustain the money's purchasing power to some extent, high inflation can swiftly erode it.

Imagine you have £100 in your savings account today. You decide to leave it there for two years to see how it grows. However, during those two years, prices for everyday things, like groceries and gas, start going up due to inflation.

After one year, your £100 will grow by 5%. So, it will become £100 + (£100 x 0.05) = £105. In the second year, your £105 will increase by 5%: £105 + (£105 x 0.05) = £110.25.

So, after two years, you'll have £110.25 in your savings account. It might seem like you've made a profit because the number got bigger, but here's the catch: Even though you have more money than you started with, the prices of things you want to buy have also gone up. In other words, the money you have now can't buy as much as it could when you first saved £100.

The real value of the cash savings after two years can be calculated as follows:

Real Value = Initial Value / (1+ Inflation Rate) ^ Number of Years = £110.25 / (1 + 0.08) ^2 ≈ £94.58

So, after two years, the real value of the cash savings is approximately £94.58.

Source: Bank of England and FRED Economic Data

The impact of time becomes crucial when evaluating the effect of inflation. Cash may exhibit better performance against inflation over short periods. However, over longer durations, cash tends to underperform, even during periods of relatively low inflation.

As evidenced in the graph, cash returns after accounting for inflation, also known as "real" returns, continue to be negative, despite the significant increase in interest rates. Negative returns imply losses.

Investing offers investors, the potential for long-term growth and the ability to surpass inflation. Although investments carry inherent risks, historical data consistently demonstrates that private market investments have delivered substantial returns. Private market investments, such as real estate, have historically acted as an inflation hedge, as their values can rise with inflation, helping to preserve purchasing power.

In the private market investment scenario, instead of keeping the £100 in a savings account, you decide to invest it in a private market opportunity. Let's assume this investment has historically shown an average annual return of 10%.

          Year 0 (Initial Investment): £100 (Invested in Private Market Opportunity)

          Year 1 (Private Market Return at 10%): £100 + (£100 x 0.1) = £110

          Year 2 (Private Market Return at 10%): £110 + (£110 x 0.1) = £121

The real value of your investment after two years can be calculated as follows:

Real Value = Initial Value / (1+ Inflation Rate) ^ Number of Years = £121 / (1 + 0.08) ^2 ≈ £103.74

As you can see, the investment in the private market opportunity outperformed the cash savings in terms of preserving and growing your wealth. While the cash savings grew, its purchasing power diminished due to the impact of inflation. On the other hand, the private market investment demonstrated higher returns, which helped protect the real value of your money and maintain its purchasing power over the two-year period.

Source: Pitchbook - Private Markets IRR by Vintage

It is imperative to acknowledge that both cash and private market investments entail risks. While cash may appear to be a safer asset, even the most attractive savings rates available today may not be sufficient to preserve the real value of deposits. Conversely, private market investments possess the potential to generate significant returns over the long term, despite market fluctuations.

Investors should carefully consider the limitations of relying solely on cash savings to combat inflation. Diversifying investments into the private market offers potential for long-term growth and outpacing inflation. However, cautious approach and expert guidance are essential to mitigate risks. Investing provides a means to preserve and grow wealth in the face of inflation, making it an attractive option for affluent investors.