Article author: Daniel Clarke, Paraplanner, GSB.
A silver lining of the economic instability we have seen in recent times, at least for savers, has been the high interest rates available on cash deposits. Coupled with the disappointing returns and high volatility of traditional investing in the past two years, many are questioning whether stocks and bonds are worth the stress and uncertainty they cause.
Whilst it may be tempting to park all of your money in a fixed term deposit, there are several caveats to consider before making this move.
How Long Will Interest Rates Remain This High?
For investors with a medium to long term time-horizon, a switch to fixed term deposits is not going to suffice as a long-term investment strategy. High interest rates are not something that central banks can sustain in the long term, especially with inflation rates continuing to fall, and the effects of high interest rates continuing to weaken economic growth worldwide.
The indication from the US, UK and EU central banks is that they are at or near the peak of their rate hiking cycle. Once rates start to decline, the return available on fixed term deposits will follow suit.
Typically, the longer you commit to locking in your funds, the higher interest rate a bank will pay. However, banks are currently paying higher rates on short-term deposits than longer-term ones. Put simply, this means that banks anticipate a sharp decline in interest rates in the near future, and therefore are not willing to pay these high rates in the medium to long term.
In one year’s time when your fixed rate deposit expires, you may not be able to secure a similar rate of interest.
Cash Deposits Vs Inflation
The thought of earning a return on a theoretically risk-free asset sounds great until you factor in that inflation will almost certainly be higher. This means that you are actually generating a negative real return. With very few exceptions, the rate you earn on a fixed term deposit will always be lower than the inflation rate.
Putting your money in a fixed term deposit is therefore a sure-fire way to lower the value of your money over time. For an elderly client with a large retirement nest egg, a return slightly below inflation may be acceptable, as they are likely more concerned with preserving their wealth as opposed to growing it in real terms. However, for most investors who are reliant on investment growth to fund their retirement, a considerable allocation in cash will not allow them to reach their retirement goals.
Cash Deposits vs Equities
It is also important to consider the risk of being out of the stock market whilst being in a fixed term cash deposit. A huge proportion of stock market returns are earned on a handful of the most profitable days. For example, in the past 30 years, if you missed the 10 best performing days in the S&P 500, your return more than halved. Missing the best 20 days reduces your return by almost three quarters.
A very recent example of this is the S&P 500 rising by 10.70% in the previous 29 days (correct as of the time of writing). This is higher than the average yearly return of the index, in just one month.
It is therefore worth considering whether cash deposits really are as low risk as they initially seem, given that you run the risk of missing out on the most profitable days. If even the most gifted fund managers cannot predict when these days will be, how can you?
Conclusion
To conclude, this is not to say that cash deposits have no place in an investment strategy. In fact, we have recommended them for a number of clients, particularly for their emergency funds. The point instead is that now is not the time to throw a 30-year investment plan out of the window due to short term panic and fear. For the bulk of investors, a portfolio of low-cost stock and bond funds held over the long term remains the best investment strategy.
Article author: Daniel Clarke, Paraplanner, GSB
https://www.linkedin.com/in/danielclarke2000/
wealthmanagement@gsbglobal.com
THIS ARTICLE DOES NOT CONSTITUTE TAX OR LEGAL ADVICE AND SHOULD NOT BE RELIED UPON AS SUCH.
THE VALUE OF YOUR INVESTMENTS CAN GO DOWN AS WELL AS UP AND YOU MAY GET BACK LESS THAN YOU INVESTED.
THE TAX TREATMENT IS DEPENDENT ON INDIVIDUAL CIRCUMSTANCES AND MAY BE SUBJECT TO CHANGE IN FUTURE. FOR GUIDANCE, SEEK PROFESSIONAL ADVICE.