As Financial Advisers, a common question we are asked, given the current market volatility and high inflation, is whether they would be better off investing in term deposits, given that New Zealand banks are now offering 5.50% – 6.00% per annum for a 12-month term deposit.
The answer to this question is that investing in term deposits and long-term diversified investment portfolios are two very different strategies with different levels of risk and potential return. Understanding the differences between the two is crucial for investors when making investment decisions.
What are Term Deposits?
Term deposits are low-risk investments that offer a rate of return for a fixed period, typically between 3 months and five years. They are a popular choice for investors looking for a safe place to park their money to meet short-term investment objectives.
What is a diversified investment portfolio?
On the other hand, a highly diversified investment portfolio typically consists of a mix of assets, such as equities, real estate, and bonds and considers a long-term investment horizon. It is designed to provide higher potential returns over a longer period. While the returns are not guaranteed and can be volatile in the short term, a well-diversified portfolio historically outperforms term deposits over the long term.
The difference is the level of investment risk
There are a number of differences between term deposits and investment portfolios, the key being the level of investment risk. Term deposits are typically considered low-risk because the investor can receive their principal investment plus a fixed interest rate in a low-risk environment, although due to inflation, the investor’s purchasing power can be eroded over time.
On the other hand, diversified investment portfolios can hold more investment risk because the returns can fluctuate with market conditions in the short term. However, over the long term, a well-diversified portfolio can provide higher potential returns than term deposits and better keep up with inflation.
According to S&P Dow Jones Indices, the annualised returns of the NZX50 from 2013 to 2023 have averaged around 11.43% p.a.[1], while the average interest rate on a 6-month
term deposit over the same period was about 3.00%,[2] and inflation averaged 2.1%[3].
Liquidity
Another key difference between term deposits and investment portfolios is liquidity. Term deposits are typically locked in for a fixed period, meaning investors cannot withdraw their funds without incurring penalties. On the other hand, investment portfolios are generally more liquid, meaning investors can sell their assets and withdraw their funds at any time.
Summary
Whenever faced with an investment decision, it is essential for investors to be guided by their financial goals, investment time horizon, and a thoughtfully crafted Financial Plan. As discussed in this article, term deposits and diversified investment portfolios are two different investment strategies, and it is important for investors to avoid comparing the two based on short-term data when making important financial decisions. A Financial Plan is a roadmap that can help you make informed financial decisions when faced with market volatility, term deposit rates, and inflation data.
If you have any questions, talk to your Financial Adviser or contact us here.
by James Howard, Financial Adviser, Cambridge Partners
26 April 2023
[1] https://www.spglobal.com/spdji/en/indices/equity/sp-nzx-50-index/#overview
[3] https://www.rbnz.govt.nz/statistics/series/economic-indicators/prices