Cash, bonds or shares?
If you have “$x” to invest, one option is to put it in the bank. This is known as a “cash” investment. Before tax, this is likely to return 5.75% p.a. to 6.0% p.a. over the next 15 to 20 years, though the gross return in any year will probably vary between 3% and 9%.
The attraction of such an investment comes from:
- the convenience of making the investment.
- the certainty of the return in the immediate future.
- the security of your capital, i.e., unless the bank goes under, you will get your money back.
- the flexibility of the investment.
- the fact that administration fees and management fees, are not directly incurred.
- the current “low” level of inflation.
At the lower end of the expected range and after tax, at 30%, and inflation of, say, 2.5%, bank deposits give an expected net real return of 1.5% p.a..
|Tax @ 30%||1.72%|
|1.53%||(real net return)|
Even if inflation is higher (3% p.a. say), you will still normally get a positive average return after-tax and inflation i.e. if you invest your money, then together with the return, it will buy more goods in a year’s time than it can today.
Bank deposits are easy and very flexible. However, bank deposits may not be the best investment if your intended period of investment is 5 to 10 years, or if you need a higher level of income. Also, if your investment period is 5 to 10 years, there is no guarantee that inflation will stay low. With cash investments there is little margin to protect an investor against unexpected inflation.
As an alternative, by leaving a little of the “$x” in cash (for a rainy day and your expenditure over the next few years), and investing the balance in, say, fixed interest or bonds, the expected return increases. Good quality, but reasonably safe, bonds are expected to return 7.5% p.a. to 8.0%1p.a. over the next 15 to 20 years.
Of course while the average return is higher, to get the higher return, your money is “tied’ up for the duration of the bond. If you were to need it sooner, you may have to take a loss when you try to sell it before the end. That’s why you need to keep some money in bank deposits for a rainy day. Still, if you are investing for 5 to 10 years, overall it will be better, on average, than only money in the bank. You could also buy a bond with a higher yield but it would not be as secure. Also, not all bonds paying 7.5% to 8.0% are secure. You still need to be careful and possibly retain some in government bonds.
Of course, if you are investing for 10 to 20 years or longer, e.g. for your retirement, you may be better to have some of your money in shares. Longer term (10 to 20 years), shares are expected to return, on “average”, 10% to 12% p.a. before tax.
The problem with shares is that while, over the long-term, they may average 10% to 12% p.a. gross, they won’t every year. In fact in any year, the return may often be as low as, say, -20% or as high as 45% or possibly lower and higher. If you may need your money back in a year’s time, you would probably not want to risk getting the -20%. However, if you don’t need your money for at least 10 years, investing in shares should provide you with a better average return than cash or bonds, but will give you some highs and lows along the way.
In practice, most investors have some short-term needs, some medium term needs and some long-term needs. This is why some cash, some bonds and some shares, often gives the best result.
Investing in bank deposits or cash is the short-term safe, flexible option, and for many people this is the right option. However, by accepting a little less flexibility, and being willing to invest your money for longer, (as you may get a loss if you cash them in short-term), you should be able increase your returns by investing in bonds and/or shares. The amount of money you allocate to each of cash, bonds and shares is called your “investment strategy”. This is one of the most important decisions that you will make.
1Assumes investment grade corporate bonds. Government stock is more likely to return 6.25% to 6.5% p.a. on average.