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March 05 newsletter

It is not uncommon for New Zealanders to have hundreds of thousands of dollars invested in bank term deposits.

This newsletter aims to highlight the risks associated with having your wealth tied up in term deposits.

Of course, it is important to realise that term deposits are an effective investment for the right objective. Term deposits are useful when the investment goal demands security and low risk of default. For example, if you're saving towards a house deposit which you intend to use over the next year or so, term deposits provide a short-term, decent return, with little risk of default by your bank (customers of the Bank of New Zealand in the 80s may beg to disagree).

If your term deposits are for the longer term, then you may be exposing your investments to some of the following risks.

1. Inflation Risk. Term deposits will not protect you from inflation. While today's inflation climate is relatively benign, your real return - that is the return after inflation - is still not very high. In the eighties, investors in term deposits were going backwards (quickly) as inflation rates were consistently higher than the interest rates investors received.
2. Interest Rate Risk. You are subject to interest rate movements - particularly downward. If interest rates fall from 6% to 3%, your income is cut in half.
3. Liquidity Risk. If you suddenly need some of your funds, you may have to break an investment, meaning that you are likely to lose most of your interest income on that particular term deposit.
4. Growth Risk. Long-term investors should expect to see their investments grow. Term deposits are not growth assets.
5. Tax risk. If you earn interest income you will pay tax. If you invest in growth assets, it is highly likely that you pay less tax.
6. Diversification risk. Diversification is not having all your investment eggs in the term deposit basket. While the risk of default, that is, of not getting your money back, is low, the risk of your real income falling is high.

There are a number of very good reasons why investors prefer term deposits. the Shape of Money regularly comes across clients who have substantial sums invested in term deposits. It's easy. One call to your bank and it's all done. There are no fees and little chance that you'll lose your capital. There are two more reasons that sometimes apply: investors have a lack of knowledge about alternative investment options and/or there is a lack of trust in the financial advisory industry.

the Shape of Money recommends that if you have a substantial portion of your investments in term deposits, then please consider assessing those investments against your investment goals.

the Shape of Money website is comprehensive and contains information and resources that may help you.

An alternate, independent publication that may be useful is Mary Holm's Snakes & Ladders A guide to risk for savers and investors. This can be obtained free from the Reserve Bank.