Paul's Insights: In a low rate world, keep an eye on fees
The Reserve Bank's back-to-back rate cuts in June and July are great news for anyone with a home loan. They're not so good for anyone trying to grow savings - or for those who rely on savings as a source of income.
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.