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This article appeared in the May 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Term deposit cash 'security' does not mean risk-free.

Photo of Robin Bowerman By Robin Bowerman, Vanguard

Cash is the king of today. But no one can predict with certainty what tomorrow holds.

Much has been written about the fact that Australia's economy came through the GFC largely unscathed and without dipping into recession.

A lot less has been written about the fact that Australian investors have enjoyed something of a honeymoon, with bank term deposits offering a secure haven and a relatively high real rate of return through the GFC and the subsequent malaise affecting the US and European economies.

US investors in particular would have loved to have had a government-backed investment paying about 5 per cent a year compared with their government bond issues that at times carried an interest rate close to zero.

But that is the past and one of the dangers for investors is to assume that what is working well today can be extrapolated forward. It is timely to remind ourselves of the health warning that applies to all investments - that past performance is no guarantee the future will deliver the same outcome.

Huge shift in investor thinking

Term deposits come with a high degree of capital security but that does not make them risk-free if interest rates were to fall significantly around the time of reinvestment, or inflation was to rear its head and erode real buying power.

Research by Investment Trends makes the strong point that there has been a seismic shift in the way cash is perceived, in investors' minds at least, away from being a parking place awaiting the next opportunity, to a definite part of the asset allocation mix.

That is completely understandable given recent history, and a higher allocation to cash has been something of a perfect portfolio recipe for individual investors.

The impact of holding more cash for the six years ended 30 June 2010 is highlighted in the latest newsletter from actuaries Rice Warner, which compares the returns of large funds overseen by the Australian Prudential Regulatory Authority (APRA) with self-managed super funds (SMSFs) regulated by the Australian Taxation Office (ATO).

The APRA funds had a gross average return of 4.9 per cent for the six years ended June 2010. For SMSFs, the gross return was 8.5 per cent, which is a stunning result given the market events in those six years. But the critical question trustees of SMSFs need to ask themselves is whether that was a demonstration of skill or was it luck?

Presumably it was not investment skill because if it was, the investment professionals managing and advising the larger super funds would have achieved similar results.

Rice Warner believes several factors explain the performance difference, the critical one being the asset allocation strategy many SMSFs use of shifting proportions of their assets to term deposits prior to and into retirement. That delivered solid returns but also meant SMSF trustees have not had to sell depressed assets into a falling market to meet their liquidity needs.

So short-term cash reserves served SMSFs well in recent years.

Understanding diversification

But, as Rice Warner argues, that six-year period may not be typical of future long-term results. With some $512 billion sitting in bank term deposits, according to Reserve Bank data in February 2012, now may be a reasonable time to gain a better understanding of the broader role of fixed interest in a portfolio and, in particular, the value of diversification.

Fixed-interest securities issued by governments and other high-quality issuers are defensive types of assets by their very nature, which can be relied upon to anchor portfolio returns in times of poor economic growth, equity market downturns or market volatility. While valuations of other assets may fluctuate according to interest rate and economic cycles, the prices of fixed-interest securities are less volatile through time than share prices and most other financial asset prices.

As a consequence, the distribution of fixed-interest returns is significantly different to that for equities, which underlines fixed interest's diversification value to a portfolio.

That is why diversification across asset classes is a concept reasonably well understood, so the concern is more around the lack of diversification within the fixed-interest market because of the build-up within bank term deposits.

The fundamental point to be made is that there is a lot more on offer within the fixed-interest market than just term deposits. Fixed interest covers a wide risk spectrum; cash (including term deposits) in the professional investing world is regarded as a sub-set of the fixed-interest market.

As the baby-boomer generation hits retirement age, the need to better understand the breadth and depth of this market, and the tools to access it, looms as a real challenge as investors manage their retirement income needs.

About the author

Robin Bowerman is Principal, Corporate Affairs & Market Development, at Vanguard Australia.

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