Author Katrina Shanks, CEO Financial Advice NZ Article originally published on Stuff.co.nz.
You don’t need to look too far to see we’re going through a period of rising prices.
Be it the grocery bill or the tank of petrol, and everything in between, prices seem to be rising every week.
Sometimes it’s not by a lot but it doesn’t take long to add up.
That hits our spending power and how much we have left over to spend on other nice things – or to invest for our future.
When it comes to investing, it’s vital to remember rising inflation erodes any gains you may make from your investments, so it pays to choose carefully where to put your money.
I recently wrote here about the four main investments to protect your money from the erosion of the inflation – shares, property, cash, and fixed interest.
I’ve discussed shares and property in depth, and how over a longer period of time (allowing for peaks and troughs) they will do a great job in helping your money stay ahead of the rate of inflation.
So, what about cash investments?
These include all your savings in a bank account, including term deposits or just sitting in an on-call account.
Term deposits lock your money away for a set period of time. This can vary from as short as three months up to two years and more.
The upside is the longer the period of your term deposit, the higher interest you will earn on your money, and that’s guaranteed level of return that won’t change at all even if all other rates do. It’s basically a contract with the bank, and once you’re locked in on your rate, it stays that way.
The downside is you can’t withdraw your money until the end of the agreed term – unless you want to pay a penalty, such as missing out on all the interest you earnt before you withdrew your investment, and perhaps even a fee, depending on how early.
An on-call account, on the other hand, allows you to withdraw your money at any time, but for that privilege, your money earns less interest. In fact, this is where your money earns the lowest amount of interest of any investment. But if it’s in a reputable bank, you can be almost 100% sure you will at least get all your money back.
Let’s say out front that cash is an incredibly low-risk form of investment that will potentially provide a small but stable amount of return. Low risk means low level of return.
Earnings from cash savings are at their best when mortgage interest rates are high.
And that’s why people who have had their savings in cash over the past two years of low mortgage rates have had little return on their savings. Thankfully, that was partly offset by inflation also being low.
But that’s now beginning to change as the Reserve Bank pushes up the Official Cash Rate (which governs the level of mortgage rates), and as that goes up, then interest on bank savings will slowly increase.
Because cash is safe it is a valuable part of a balanced portfolio, which may be made up with riskier shares and property investments.
It’s also worth remembering you have to pay tax on any interest you earn on your savings – not tax on your savings but on the interest they earn.
Cash is best for those who have short-term goals and don’t want to lose their money. It’s much safer over the short term than shares and property, which are always subject to market fluctuations and are better long-term investments.
For people nearing retirement it can be a good option to have another look at your risk tolerance. This may mean selling a portion of your shares and property and move money into a cash investment where there are fewer fluctuations and it’s safer. This will balance your portfolio better to reflect appetite for risk. It could be better getting a lower return that is near-guaranteed than risking it in something more speculative.
But the key is to see if you can get an interest rate that’s higher than the rate of inflation. If not, your purchasing power will be reducing on those funds.
Here’s a perfect yet simple illustration of what I mean:
If you invested $100 at 2% interest, you would have $102 in your account at the end of the year. But if inflation was running at 3% you would be worse off because you would need $103 in your account to have the same buying power you had when you opened the account.
And on top of that you would have to pay tax on the $2. If your marginal (top) tax rate was 33%, your $2 gain would shrink to around $1.40.
Remember, any time savings don’t increase at or above the rate of inflation means you are losing money.
To sum up, putting money into a savings account won’t likely be enough alone to meet your long-term goal. But it could be a safer part of a bigger investment plan or portfolio that includes shares, property, and also things like fixed-interest bonds.
As the legendary US investor Warren Buffett, whose 2022 value has been estimated at US$127 billion, once said: “We always keep enough cash around so I feel very comfortable and don’t worry about sleeping at night. But it’s not because I like cash as an investment. Cash is a bad investment over time. But you always want to have enough so that nobody else can determine your future essentially.”
I personally have a mix of managed funds which I know have an element of low risk investments – including cash and fixed interest. Most investors (which is you if you have KiwiSaver which also have this mix). But you should have a look on your app and see the mix of your KiwiSaver investment.
In the words of my adviser – Cash is great but it needs to be combined with other investments which build on your future goals and needs. Stay to your plan. And breathe.