, , , ,

One difference between economists and investors is how they approach the concept of inflation. According to the first group, inflation is the rise in the price level, without any negative connotations. Investors, on the other hand, think of inflation in a different way. They assume that it is the loss of purchasing power of money, that is, a source of negative return on investments, such as taxes. Most economists assume that a moderate increase in prices is good for the economy, while every investor think of inflation in a negative way. While the first ones might be wrong (and, in fact, a minority of economists prove that inflation is bad for the economy), investors are unmistakably right: whenever prices increase, the value of cash decreases, so cash-holders become poorer and the of the real notional value of assets decrease.

And here comes the main risk of being an extremely conservative, risk averse investor: cash is not volatile and its (nominal) value is fixed, but it losses real value each year due to inflation. The historical annual increase in prices has been around 2-4%, with few periods of negative inflation. According to the Federal Reserve Bank of St. Louis, since 2013, there has been just 13 years of deflation in the US, with very little decrease in prices. That is, the norm is that cash losses value, and the exception is that its purchasing power increases. The reason for this is straight forward: “inflation is taxation without representation”, as Friedman said, so governments are tempted to create this phenomenon. This fact, together with the fact that central banks have a long-term positive inflation target, leads us to think that in the next decades we are going to suffer at least a 2% inflation.


Hence, holding cash just assures the saver that he will lose for sure at least a 2% annualized. Thinking in nominal terms is a typical investment bias and the first step to achieve financial independence is to set objectives in real terms, not nominal. For a conservative investor, the financial goal should be to preserve his purchasing power instead of maintaining the nominal value of his savings. Therefore, even though cash plays a key role in investing, it should not be the bulk of the portfolio, at least in the long run.