Return OF capital versus return ON capital

30 July 2021

reading time:  minutes

Returns on savings accounts and term deposits are dismal at the moment.

As I write this, interest.co.nz lists returns on 12-month term deposit rates from 0.5% to 1.35% (mean of 1.13%). For 5-year rates, returns vary from 0.5% to 2.05% (mean of 1.65%).

The rate of inflation (measured via the Consumers Price Index (CPI)), in contrast, is 3.3%! (That’s for the year to June 2021. Prior to this it was around 1.4% to 1.5%.)

If you’re holding money in savings accounts or term deposits with short maturities, this means that inflation is likely to be eating away at the purchasing power of your money.

But that might still be the most appropriate way to invest.

It ultimately comes down to when you plan on using the money.

If you need the money at some point in the near future, then it’s likely that this is still one of the best things to do with your money, even if the returns are dismal.

If you need the money in the short-term, your focus should be return of capital rather than return on capital.

Risk is relative. The risk isn’t missing out on an extra 1% or 2% in purchasing power. The real risk is the value of your investments dropping by 10%, 20%, or 30% and not having what you need, when you need it.

Let’s put it in visual terms. Below is a set of 149 scenarios generated by FIREcalc. The scenarios are based on an initial investment of $1,000, with these funds invested 100% in equities with annual fees of 0.5% over the course of two years.

Basically, this chart shows 149 historical instances of investing $1,000 in this way, with the only difference in each instance being the year that the $1,000 was invested. One line represents $1,000 invested in 1919, one in 1932, one in 1986, one in 2010, etc.

There are lots of instances where this $1,000 turned into more than $1,000. In some cases, significantly more. On average, the portfolio ended at $1,160.

There are, however, quite a few instances where the $1,000 didn’t grow by much – or at all. In some cases, the $1,000 dropped significantly.

(In fact, in 79% of all scenarios, the portfolio dropped below $1,000 at some point over two years. In most cases, this would have been near the start of the two year period. In any case, you need to expect that your portfolio will probably drop, at least for a period of time.)

If you need the money, then it makes a lot of sense to simply lock in a return and be certain about your outcomes.

What about bonds?

If you need money in the foreseeable future, it’s often best to keep it in a savings account, or a term deposit (if you know when you’ll need the funds and can match a maturity to suit).

If you don’t need to invest in this way, you might be interested in increasing your exposure to bonds (often referred to as “fixed interest” investments).

I characterise bonds as being conservative investments, in the sense that in a fundamental way, your investment is likely to be pretty safe, so long as the bonds in question are issued by a Government a reputable private company.

A Government doesn’t want to ruin its reputation by failing to pay its debts. It can almost always come up with the money – by printing money, taxing more, or spending less on other things. If a private company is having financial issues, at least it will need to repay its bonds before it repays its shareholders.

Returns from bonds, however, can be more variable than returns from savings accounts or term deposits. This is because bonds can be traded, and the value of the bonds themselves can go up and down based on changing interest rate expectations.

With bonds, the value of your investment can also reduce. This is usually far less pronounced than with shares, but the impact can still be significant.

Let’s get visual again. Below is another set of 148 scenarios, except the portfolio is invested in fixed income investments (“long interest rate”) over two years.

The trend is similar to shares – but far less pronounced. On average, the portfolio ended at $1,042. But there were far less instances of the portfolio reducing substantially. The worst-case scenarios aren’t as bad as the worst-case scenarios with equities.

(In this instance, there was still a majority of scenarios – 77% – where the value of the investments dropped below $1,000 at some point.)

(Can't we predict what will happen with bond returns? I'm sceptical about this, for similar reasons for why I'm sceptical about anyone's ability to reliably beat the market when it comes to publicly listed shares. Bonds are traded on financial markets, the same as shares. The value of any given bond represents the consensus view of investment professionals trying to pick what the future holds for these specific bonds, and the bond market in general. Expectations about changes to interest rates, inflation, and the like are already built into prices.) 

What matters to you?

If you think you might need the money in two years’ time, what is more important to you? Is it the return? Or making sure the money is available when you need it?

For most people, the shorter the time frame, the more weight you should give to variance rather than averages. You’ll probably end up better off by investing in shares, but the bigger factor is avoiding the scenario of not having what you need when you need it.

If you don’t need the money in the foreseeable future, then you should consider investing more aggressively

Again, this comes down to your circumstances and needs. If you aren’t likely to use these funds for, say, 10 or more years, does an immediate downturn pose a significant risk to you?

As time goes on, variance tends to become less important. The risk of short-term volatility should be weighed far less heavily if you are looking at the long-term.

Where your focus is the long-term, the risk of ending up in a worse position should be weighed more heavily.

In this case, investing too defensively is a risk in itself. 

Consider the same two sets of scenarios, except over a period of 10 years, rather than two years.

100% equities:

100% fixed income:

The average portfolios are $1,995 and $1,233 respectively.

Whatever your time frame, risk is relative. It all comes down to your personal circumstances, needs, and objectives.

A good rule of thumb: if you need money in the short-term, weigh return OF capital more heavily than return ON capital. Over the long run, give more weight to return ON capital.


Tags

bonds, equities, long-term, mean, return of capital, return on capital, savings, shares, short-term, term deposits, variance


About the author 

Sonnie Bailey

Sonnie provides financial planning services via his business, Fairhaven Wealth (www.fairhavenwealth.co.nz). Fairhaven Wealth provides independent, advice-only, fixed-fee financial planning services. Sonnie is also a “recovering lawyer”: he has specialised in financial services, trusts, and estate planning.

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