Paul's Insights: In a low rate world, keep an eye on fees
At times like these, investments offering what appear to be strong returns can be attractive.
But no matter the economic environment, the golden rule of investing always applies. Higher returns always come with higher risk. So, yes, it can be possible to earn a higher return, but it means taking on more risk.
In keeping with this time-honoured relationship between risk and return, the returns on cash will typically be the lowest of all. Of course, cash doesn’t always generate the lowest returns. It has certainly outperformed some property markets over the last two years. As an overarching rule though, the price you pay for less risk is low returns.
Reserve Bank figures for example, show bonus savings accounts (which usually impose simple conditions to earn the top rate) are currently paying an average of 1.95%. Both 1- and 3-year term deposits are paying around 1.80%.
It’s not much of a return, especially when you consider inflation is sitting at 1.3%.
The problem is that some investments marketed as ‘income-based’ can offer a higher rate. It’s a fair bet they also come with higher risk. And, as it often requires more effort to deliver a higher return, these investments can charge higher fees.
If you see an investment offering a high return, ask ‘Why?’ If term deposits are paying between 1.80% and 1.95% (usually with zero fees), an ‘income’ fund has to be investing in higher risk assets to pay a higher return. You need to understand what those risks are.
On the other side of the ledger, always look at the fees you’ll pay.
If you’re paying annual fees of, say, 1.5%, your money needs to earn at least 2.8% just to stay abreast of inflation (remember, that’s 1.3%). As I’ve mentioned, to be able to earn this sort of return, it’s a no brainer that more risk is also involved.
I’m not saying risk is to be avoided. If you take no risk, you get a low return. But you must be aware of the risks of any investment.
Consider how much risk you can sleep with, and weigh up whether paying more in fees to earn a slightly higher return is worth the extra risk. This is especially important because fees are set in stone, but returns are rarely guaranteed.
Paul Clitheroe is Chairman of InvestSMART, Chairman of the Australian Government Financial Literacy Board and chief commentator for Money Magazine.
Frequently Asked Questions about this Article…
Higher returns come with higher risk because, in the investment world, the potential for greater rewards usually involves taking on more uncertainty. This is a fundamental principle where safer investments like cash offer lower returns, while riskier assets can potentially yield more.
According to Reserve Bank figures, bonus savings accounts are currently offering an average return of 1.95%, while 1- and 3-year term deposits are paying around 1.80%. These returns are relatively low, especially when compared to the current inflation rate of 1.3%.
Fees can significantly impact investment returns. For example, if you're paying annual fees of 1.5%, your investment needs to earn at least 2.8% just to keep up with inflation, which is currently at 1.3%. This means that higher fees require higher returns to maintain purchasing power.
When evaluating an investment offering high returns, it's crucial to ask 'Why?' and understand the risks involved. High returns often mean the investment is in higher-risk assets. Additionally, consider the fees associated with the investment, as they can eat into your returns.
Fees in investments are typically fixed and set in stone, unlike returns, which are not guaranteed. This makes it important to carefully consider the fees you will be paying, as they will affect your overall investment performance.
Yes, cash investments can outperform other asset classes in certain situations. For example, over the last two years, cash has outperformed some property markets. However, as a general rule, cash investments usually offer lower returns due to their lower risk.
Deciding the level of risk you're comfortable with involves considering how much risk you can 'sleep with.' Weigh the potential for higher returns against the extra risk and fees involved. It's important to align your investment choices with your risk tolerance and financial goals.
Understanding the risks of any investment is crucial because it helps you make informed decisions about where to allocate your money. Knowing the risks allows you to balance potential returns with your comfort level and financial objectives, ensuring that you are not caught off guard by unexpected losses.