Whenever you put money into a fixed deposit you probably think that it is perfectly safe. And as long as that deposit is running, you are probably right.
If, for example, you invest in a in 36-month fixed deposit, you are guaranteed a certain interest rate for those three years. You are also almost certain to get your money back unless some catastrophe strikes the bank.
But what happens when that time is up? This is when a risk arises that most investors never even think about.
Because 36 months from now, the interest rate will almost certainly have changed. And that creates something called reinvestment risk – the risk that you might not be able to invest your money again at the same rate.
Why does it matter?
While this might sound theoretical, it does have real implications. If you are using the interest you earn from a fixed deposit to pay for your expenses, you can’t afford for the income you are getting to suddenly change. You need to keep earning that money to maintain your lifestyle.
But the difference in interest rates from year to year can sometimes be substantial. This has been evident just over the past few years.
In March 2018, the prime rate in South Africa was 10%. Three years later, it was 7%.
This means that if you had invested R3 million in a 36-month fixed deposit at the prime rate back in 2018, you would have earned interest of R300 000 per year, or R25 000 per month. But when that deposit matured, you could only reinvest it at a rate that would earn you R210 000 per year, or R17,500 per month.
That is a drop in income of 30%.
Managing the risk
This reinvestment risk does, however, differ for different types of investments. Someone who is investing in a 12-month fixed deposit, for instance, has to reinvest their cash every year. And they will be getting a different interest rate every time.
Someone who puts their money into a five-year fixed deposit, on the other hand, will have an interest rate set for that entire time. That gives a longer period of certainty, even if it doesn’t remove the risk altogether. Because when those five years are up, things could have changed dramatically.
Putting your money into a fixed deposit for that long also comes with other risks. If your money is tied up for 60 months, you won’t be able to access it if your life circumstances change in a big way.
You can also manage reinvestment risk by matching when the fixed deposit will mature with your time horizon. For example, if you know that you will need money in five-years’ time for something else, such as buying a guaranteed retirement annuity, then you can match that with the term of your investment.
The best approach, however, is usually to think about diversifying your portfolio. Even though the stock market or other assets might seem riskier than a bank deposit, it’s worth remembering that every investment comes with some type of risk.
And the best way of mitigating risks is to be exposed to a range of them. That way if something goes wrong in one area, it doesn’t derail your entire portfolio.
If you need an income, dividend paying stocks are a good alternative. So are bonds and listed property.
And if you invest in these through a unit trust you don’t have to worry about reinvestment risk, because you can hold the investment for as long as you like.
To discuss your investment risks, speak to a professional.
Disclaimer: The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your professional adviser for specific and detailed advice.