Opportunity Cost of Term Deposits

One of the fundamentals of investing is the time value of money. If you make an investment with your capital, you need to be compensated for the use of your money. Generally speaking, the longer the investment term the higher the return.

If you invest in term deposits, you are compensated by receiving an agreed amount of interest. If you invest in a balanced portfolio, you can be compensated in two ways, first by receiving regular income distribution from the underlying investments. The second way is by capital appreciation, that is the price of your underlying investments goes up, which then drives up the value of your balanced portfolio. When you add the income return to the capital appreciation, this is called your total return.

An investment should match your investment time horizon. In risk management terms this can also be likened to matching your assets to your liabilities. If you have short-term liabilities, then you need to have some short-term investments to pay for your liabilities (in-case your income cannot cover your costs). The same applies if your liabilities are long-term (i.e. retirement spending plans), then your investments should be longer-term.

All investments have a ‘suggested’ minimum investment time horizon. Everyone will have their own unique financial position and therefore require their own investment time horizon. A Financial Adviser can help you determine which time horizon is appropriate for you, based on your personal financial situation.
One of the major pitfalls of investing in term deposits is the ‘Opportunity Cost’. For example, if you invest in term deposits, you are not investing in a balanced portfolio and over time, the balanced portfolio should outperform term deposits.

If we look at the last 40 years of New Zealand term deposits and a typical balanced portfolio’s performance, we discover that the balanced portfolio outperformed term deposits by 3% per annum, after fees and tax, (see chart below). The 3% out-performance of balanced portfolio would be considered the ‘lost’ opportunity cost, of investing in term deposits.

*Performance figures for a Balanced Fund are after tax (33% up to 31/3/08, 30% from 1/4/08 to 30/09/10, and 28% from 1/10/10, reflecting use of the Portfolio Investment Entity tax structure from 1/04/08).  Term Deposit returns are after tax (33% up to 30/09/10, and 30% from 1/10/10).

There were only two periods over the last 40 years where term deposits outperformed a balanced portfolio and that was during the Dot.Com share-market correction (2002-2005) and then during the Global Financial Crisis (2008-2012).  Outside these two periods, a typical balanced portfolio outperformed term deposits.

Conclusion

It is critical that investors identify their investment time horizon and match their investments to their spending and / or retirement objectives.  If you have a long-term investment horizon and you are fully invested in term deposits, you have missed out on 3% return per annum of extra return over the last 40 years!

If you are fully invested in term deposits, a KiwiSaver default fund or a defensive portfolio and you have an investment time horizon greater than 5-7 years, please speak to your financial adviser.

Article By Joe Byrne, Ba, AFA - Read More