With interest rates rising rapidly over the last 12 months, term deposits are back in favour with income investors.
Term deposits are financial instruments that let you invest for a set amount of time and receive a fixed interest rate.
Given that they are classed as risk-free, they are popular with investors with a lower than average risk appetite.
However, there are hidden risks that investors should be aware of before choosing term deposits over other investments, such as ASX shares.
Term deposits vs ASX shares
If you want peace of mind and capital preservation, it is hard to fault term deposits.
However, in the current environment, you're not truly preserving capital because of inflation, which currently stands at 7.8% according to the Reserve Bank of Australia.
For example, if you were to invest $1,000 into anything, you would need to generate a 7.8% return just to break even because of inflation. Anything less and your purchasing power for that $1,000 will reduce accordingly.
So, with Commonwealth Bank of Australia (ASX: CBA) currently offering 3.85% interest rates on 12-month term deposits, inflation is still eating away at 3.95% of your wealth. This effectively means your $1,000 is now worth approximately $960 in real terms.
So, with ASX shares providing investors with a 9.55% per annum average annual return over the last 30 years, you arguably stand more of a chance of beating inflation and growing your wealth in the share market.
Though, unlike term deposits, it is worth remembering that there is no guarantee that ASX shares will deliver those returns again. But you do have history on your side.
Opportunity cost
In addition, taking inflation out of the equation, if you're investing for a long period in term deposits, there is your opportunity cost to think about.
For example, if you invest $1,000 into a term deposit for 10 years at 3.85% per annum, you will grow your investment to just under $1,460. That's a return of 46%.
However, if the share market delivers a 9.55% annual return over the same period, $1,000 invested in ASX shares would turn into just under $2,500. That's a 150% return and more than triple what you would generate with a term deposit.
It's all about risk and reward. Ultimately, investors should do what is right for their risk profile.
