Three reasons why holding cash may work against you
If you feel like it's harder than ever to get a good return on your money, you're right.
We're currently living in an ultra-low interest rate environment, which means the return you get for putting your money in the bank or into an investment is likely much lower than in the past.
While this low-rate environment is necessary as we ride out disruptions from the COVID-19 pandemic, the downside is what it means for Australians who want strong returns on their money without the risk.
Where does this leave you?
It's likely you are holding more money in your savings account than before the pandemic, maybe a lot more.
In early 2020, when the economic impact of the pandemic created a lot of fear and uncertainty, Aussies were saving more than 20% of their take-home pay, according to the Australian Bureau of Statistics.
A year on, we're still saving more than 10% of our take-home pay.
To put this in context, in the early 2000s when economic conditions were good, interest rates were higher, wages were rising and job security was good, Aussies were saving almost none of their take-home pay. We were a nation of spenders, and we felt secure.
While it's not a bad thing that we are saving more, low interest rates mean we are getting almost no return on our savings. In fact, you may even be losing money.
Here are three reasons why need to look carefully at your own situation, and take action to protect the returns on your money.
1. Cash can lose value over time
The Reserve Bank of Australia (RBA) has slashed official interest rates to 0.1%, the lowest level in history. It has repeatedly stated that it will not raise rates for at least the next two years. This has translated into the major banks offering low term deposit rates, which have averaged 0.29% for the past 12 months, according to RBA/Bloomberg data.
Let's look at an example of the impact of low interest rates: If you placed $100,000 in a savings account in 2016, then based on the average annual interest rate available over this period of 1.4%, your money would have grown to $107,200.
However, inflation over this timeframe averaged 1.6%, which means you needed $108,300 to break even.
2. Tax reduces your savings and investment income further
Interest on your savings is taxed, and does not take into account the fact that inflation may already be causing you to get a negative return on your money.
The higher the tax bracket you fall into, the greater the impact you will feel. An alternative to consider is your superannuation. Money paid into your super by your employer is taxed at 15%. For low income earners, if you earn under $37,000 a year any tax paid is refunded back into your super. You can find more information on super and tax on the ATO website but it may also be wise to consult an advisor.
3. Expand your investment universe
To get your returns outpacing inflation and tax you need to invest to make your money work harder.
Many of us will know someone who has made or lost money in the share market, and we also probably know someone with an investment property. Shares and property are the two main asset classes Australians consider when they look to investment. Both have inherent risks. The share market moves up and down, depending on the health of the economy and the company you choose to invest in. Property tends to be an illiquid, long-term investment, requiring substantial funds upfront. But both can be great investments over time.
Less risky are corporate bonds.
Most people are aware of government bonds. These are the safest type of bond as they are backed by the government that issues them. When you buy a bond you are effectively lending money to the country that issues it, with an understanding your money will be returned at a pre-determined time, and you will receive interest payments along the way.
Unfortunately, the interest rate you receive is heavily impacted by official rates, so government bonds, like savings accounts and term deposits, are paying virtually nothing.
But they are low risk, which is the reason some people still buy them. They are effectively prepared to have their money stagnate or go backwards for the security offered.
If you are prepared to take on a little more risk, you can look at a corporate bond. In this case you are lending money to the company you invest in, so your risk is that it does not get into financial trouble and default on its debts - much like a mortgage holder in financial stress may default on their payments.
The bond universe is huge. You can buy bonds in well-known Australian companies, like the big four banks, Wesfarmers, BHP, Telstra or Woolworths. You can also buy bonds issued by international companies you know well, like Google, Microsoft or Johnson & Johnson.
Whenever a company issues a bond, one or more international ratings agencies rates into intone of two key categories: Investment Grade or High Yield bonds. The higher the rating, the safer your investment, according to research by the ratings agency.
Companies with a very high rating will pay you less interest on the money borrowed, as the bond is less volatile. High yield bond issuers are higher risk than investment grade issuers, so they will pay more interest to attract your money. There are many names in the high yield range that are known both domestically and globally, but the more risk you take on the greater the need to ensure you have a diversified portfolio.
In the current Australian dollar bond market, Investment Grade bonds yields ranging between 2.5% to 3.5% per annum. If we look at High Yield Bonds, which come with additional risk, the yields range between 4%-6% per annum.
Why diversification matters
Different assets have different drivers for performance. For equities it's how conditions will allow a company to increase profits and the size of the company, and how that will impact dividends paid.
For property it's about supply and demand, while for bonds it's about the interest rate environment and level of risk in the global financial system.
By holding a mix of assets that are uncorrelated you ensure that even if part of your portfolio is underperforming, other parts are performing better. This is how over the long term you smooth out returns and achieve better outcomes. By introducing international assets, and even foreign currencies, you can further diversify your investment portfolio.
What should you do?
The bottom line is that you need to look at the options available to you, decide on the level of risk you feel comfortable with, and take action to get your money working harder. The returns you will receive may not be as good as you were used to in the previous decade, but that is the reality of living in volatile times and a low interest rate environment - returns across the board are generally lower.
We are going to be in a low rate environment for years to come. Even when they start to rise it will not suddenly be a return to previous decades where savings accounts and term deposits could supply the income and savings growth many required.
By taking some time to increase your investment knowledge, you will be able to grow your wealth.
This information is not advice and has been prepared without taking account of the objectives, situations or needs of any particular individuals. Any individual should consider if the information is appropriate for your own situation. Individuals are advised to obtain independent legal, financial, foreign exchange and taxation advice prior to making financial decisions. Citigroup Pty Limited ABN 88 004 325 080, AFSL and Australian credit licence 238098.
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