Q. I have maturing Term Deposits that I am looking to reinvest. Now rates are so low would I be better buying bank shares or reinvesting in a term Deposit at less than 3%?
A. The age old dilemma; “Do I buy a Term Deposit offered by a bank or do I buy the bank?” What is appropriate for you will depend upon your circumstances and your appetite for investment risk. Both capital risk and income risk.
Share prices will rise and fall in a cycle. Over time the share price of a company will range from expensive to cheap. It is important that you invest on the basis of the future prospects of shares not on how they have previously performed.
Determine your investment time horizon. Are you investing for the long term or the short term? Will you require access to the lump sum on short notice. For example if you were planning to buy a home in the short term, your plans may be jeopardised if the share value was to fall when you need access to the funds.
Likewise if you believe in the long term sustainability of a company you don’t want to be a forced seller to fund a short term capital need. For example if you were borrowing to invest, ensure you have sufficient funds put aside to meet a margin call. This will save you from being a forced seller of the underlying investments in the event of a fall in the market.
If you require certainty of income, you need to consider what income risks you bear with your investment options. For example, is a company capable of paying dividends on a sustainable basis. Do the dividends vary from year to year? What happens if they don’t pay a dividend?
There are income risks with Term deposits too. For example, investors currently looking to reinvest a 5 year Term Deposit will need to accept a 60% cut in interest rates compared to what they locked in back in 2010. Can you afford to accept the Term deposit rates on offer or do you need to source higher income producing investments and accept a greater risk of capital volatility?
Be wary of the income risk and understand the underlying investment you are invested in. If a Term Deposit is paying 2.8% and a debenture or bond is paying 7%, logic states that the higher interest rate paid is because there is greater risk in the underlying investment.
To reduce investment risk you should always look to diversify your portfolio and avoid having all your eggs in one basket. Diversify by investment and asset class. Investing in one stock or one sector is a high risk strategy and not recommended.
In all investments, there are risks; Income risks and Capital risks. Generally those prepared to accept higher risks are rewarded but you need to understand what risks you face and ensure you are receiving sufficient return (reward) for accepting those risks. In all cases base your decision on your personal circumstances.