Rate of Return vs Risk

Question

Hi Phillip

Could you give some advice to me please...we have just sold our house and are going renting for the foreseeable future 3 - 6 months maybe longer, we want to put all the money ($650k) into 3 month fixed term deposits.
Our bank (Westpac) offers a good rate but places like Pacific Retail Finance offers a couple of points more and that makes the difference after tax of about $200= a week which is very tempting.

My question is obviously the higher rate is because of a risk factor but how risky is it?

This is all our money so we are a tad paranoid

Thanks in advance for any help you can give

Louise

Answer

The flavour of your question is one that is likely to pop up regularly over the next 12 or 24 months in my view. As folk divest themselves of property that has had a good run-up in value and are looking to sit and wait until the market drops.

Market timing is fraught with problems, selling at the very top or buying at the very bottom of any cycle is tough. First, it is very hard to identify until the evidence of a change is there for all to see. Second, most market changes are not signalled with flashing lights and ringing bells, more a subtle slip or slide or trend (big share market crashes aside) and thirdly, most folk never get it just right despite trying and sometimes beat themselves up for it.

Those few that do, bask in the smug glow of hindsight (and we are sometimes envious for sure) but if push comes to shove and they are really honest - a lot of luck is needed.

You have already made the move and sold so now what’s the next step?  Sit back and invest and wait or move back into the market at a lower price point level and consolidate or step up to a higher level. All have merit.

If the rent and invest route is your fancy for such a short time ‘the rate of return or return on your capital is very much secondary to the return of your capital’ (my axiom, indeed holds true for any investment horizon actually).

Investment quality is the only road to travel. A key problem is just how can you identify quality when the daily media is littered with what seems great offers.

In the case of debentures, the annual rate of return (coupon) is often argued as an indicator of risk. The higher the coupon the higher the risk sort of theory that the great unwashed love to preach. I argue that this is not necessarily a good indicator of risk and should be considered only one component of any assessment.

I have talked previously about a publication that is a good guide when trying to select providers of term deposits and I urge you to get a copy of the KPMG FIPS survey. But I should also highlight there are other types of investments that will provide the quality outcome you are seeking – talk to somebody how knows all the options.

Remember, that just as you have deduced, the market is maybe near the top of the cycle be aware that any investment you select may also be invested back into the sector from which you have just departed – check carefully before placing your funds.

I restate my warning – firstly, it is the return of your capital that you require, and secondly the return on your capital you should consider.

Original Article published January 2006