With record low interest rates, many term deposit holders are questioning where else they can invest to maintain their income. While you can’t get away from having to take a bit more risk to generate additional returns, this may be a sensible approach, depending on your circumstances.
The RBA cut the official cash rate to a historic low of 0.75% in October, while also signalling its willingness to cut rates further if needed. Term deposit rates are already providing a negative return for some investors after inflation and tax. For example, an interest rate of 1.7% p.a. represents a negative real return of -0.8% p.a. for anyone subject to the highest marginal tax rate of 47%.
With the government guarantee for deposits up to $250,000 per account holder/entity, banks offer one of the safest investments available. This safety potentially comes at a high price, however, considering the investment return that could potentially be achieved from putting the cash to work.
Some investors with strong memories of the 2008-09 market crash may be attempting to time markets by holding cash with a plan to buy into the market after prices have fallen. However, the risk is that low interest rates extend the current market cycle for longer than expected. In contrast to previous cycles, low inflation is providing central banks with more flexibility with regards to interest rates than is typical at this stage of the cycle. In this scenario, the opportunity cost of holding cash is likely to be high as asset prices continue to be supported by easy money.
What should investors consider?
With the ultra-low returns on bank deposits, it is now more important than ever for investors to consider their investment timeframe. Once expenditure needs for (say) the next few years have been set aside, an investor can arguably justify allocating more to risky investments to generate higher returns over the longer term. Extending the investment horizon, where appropriate, may be the most viable approach to dealing with low interest rates. This does not necessarily mean investing in the share market. For instance, a managed fund or Exchange Traded Fund (ETF) holding investment-grade fixed interest securities could be expected to generate an additional 1-2% p.a. above term deposits for investors with a time horizon of at least 3 years.
Investing for higher expected returns invariably means accepting a wider range of potential outcomes - whether to the upside or the downside. The key to successful investing is having the capacity and discipline to look through shorter-term fluctuations to earn the higher expected returns over the long term. As such, your investment strategy needs to be tailored to suit your specific timeframe and preferences to ensure there is capacity to cope with market volatility. Investors holding term deposits should consider whether their need for liquidity in the short term justifies the high cost of cash. If the timeframe allows, there is a sound argument for moving up the risk spectrum to generate additional income.
Speak with a BDO Private Wealth Adviser if you have any questions around your investments and how the low interest rates could affect you.
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