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Money in the bank - is cash the best long-term option?

One of the key tenets of behavioural finance states that investors would rather receive a small, certain reward now rather than a potentially greater return in the future.

Over the past few years, this has made sense to many investors concerned with protecting their nest eggs, who have moved their savings from equities into lower-risk assets such as term deposits. Yet, with interest rates at their current low levels, now may be agood time for investors to look at some alternative options.

Cash and term deposits play an important role in most investors’ portfolios. They can help you with short-term cash flow needs, and provide relative stability and certainty during times that other investments are volatile. Term deposits have traditionally played a role in short- or medium-term savings for those looking to put money away for goalssuch as a holiday, house deposit or new car.

However, for those investors who have moved significant portions of their superannuation or investments into term deposits, there are number of factors they need to consider.

The effect of rate cuts on your savings

When interest rates fall, the impact on cash investments has a cumulative effect over time. Whether you are saving towards a goal or you are a retiree who depends on your savings to draw an income, a reduction in cash rates will have an adverse effect on your financial situation.

As the following chart shows, if you have savings of $500,000 invested in cash, and you draw an annual income of $30,000 from these savings, a 0.25% per annum rate drop would mean a loss of income of $1,175 in the first year, or 4% of your annual income. That’s quite a large loss to your income.

And the larger your savings the larger the impact of a rate cut. For instance, ifyou have savings of $700,000 invested in cash and draw the same income, you would lose $1,675 in the first year, or 5.6% of your annual income.

A 1% drop in the official cash rate would have an even greater impact. If you have $500,000 invested in cash, you would lose $4,700 in income in the first year, and with $700,000 you would lose $6,700 in income. That’s a 16% and 22% reduction of annual incomes respectively.

Impact of rate cut on cash investment over time

Rate cute Amount invested Yearly income drawn Loss of income in year one
0.25% $500,000 $30,000 $1,175
  $700,000 $30,000 $1,675
1.0% $500,000 $30,000 $4,700
  $700,000 $30,000 $6,700

Source: AMP Capital

Does interest earned account for the rise in the cost of living?

It’s also important to consider the effect of inflation on your investment over time. The real rate of return on an investment is what you will earn once inflation is taken into account. If, for example, your bank pays you 5% on your investment and the inflation rate is 3% then the real rate of return is 2%—significantly less than what you may expect.

If you are investing for a medium- or long-term goal such as saving for a house deposit or your retirement, you’ll need your savings to grow enough to reach your target, and to keep up with inflation. We believe the best way to do this is to have a mix of assets that provide both capital growth and income to help you reach these goals.

Grow your savings over the long-term

So, what are your options? Well, there are a number of options that can help grow your savings over the long-term. Below is a short summary of some of the investment options available, and how they can help you reach your financial goals:

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs.

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