Author: Leigh Jobling, Partner, TAG Financial Services
It would be fair to say that low interest rates benefit some while disadvantaging others.
In November 2020, the Reserve Bank of Australia (RBA) reduced the official cash rate to just 0.1%. The cash rate is so low today because inflation in 2020 was 0.75% (and in 2021 is forecast at 1.3%). The RBA want inflation closer to 2.5% – the measure of a healthy balance of supply and demand in the economy, providing a platform for growth.
Ten years ago, in April 2011, the cash rate was 4.75% and you could get over 5% interest on a term deposit. That’s not a bad risk-free rate of return. The inflation rate in 2011 was 3.3%, so after inflation, the “real return” from a term deposit was approximately 2%.
The benefits of low interest rates
While inflation is low, interest rates will stay low. This is designed to stimulate economic activity. Low interest rates mean businesses can expand, in turn employing more people and growing the economy. Low rates also mean the public is more inclined to borrow to renovate their homes, build an investment property or buy a new car, creating further economic activity.
Negative returns
However, low interest rates are hurting those who do not have a loan – those that rely on income from their investments (including a component of cash and term deposits) to help fund their retirement incomes.
Interest rates on a term deposit with most banks are around 0.5% and with inflation at 1.3%, the real return on your cash investment is negative 0.8%. The value of your money is eroding with time.
Generating a ‘real return’
While everyone should have some cash to cover their short-term needs, investors must look beyond cash to generate a return that provides a positive ‘real return’.
The good news is that low interest rates are positive for growth assets such as shares and property. People borrow money at cheap rates to buy these assets. Furthermore, the share market and property market are supported by those looking for a better return than 0.5%, which outpaces inflation and contributes to their wealth creation and retirement income needs.
While stepping away from the safety of cash can be unnerving for those that are inexperienced with investing, it is absolutely necessary in the current environment for the value of your money to exceed inflation and grow in real terms.
As we often need to remind people – the risk of outliving your money is far greater than the risk of losing your money. You don’t need to take significant investment risks – reasonable returns over the long term can be achieved (even in the current environment) from a simply constructed, well diversified portfolio aiming to generate returns on average of around 6% per annum.
While this portfolio can fluctuate in value over the short term, long term investors reap the benefits of such an approach – and remember, with life expectancy averaging 85+ years, most people can be a long-term investor.
Cash for many is a warm safety blanket, but presently it’s leaving your financial position out in the cold.
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Disclaimer: The information contained is general in nature. Professional advice should be sought before acting on any aspect on this page. Financial planning services provided by TAG Financial Advisors Pty Ltd (ABN 77 154 205 017 AFSL 415632), a wholly owned subsidiary of TAG Financial Services Pty Ltd (ABN 67 075 374 686). Add to the end: Copyright 2021. Please do not reproduce without the expressed written consent of the author.