Comparing Investment Strategies
Weigh up different ways to invest for NSW Year 12 Mathematics Standard 1 (NESA outcome MST-12-S1-02). Every way of investing money trades off return, access to your money and risk, so the best choice depends on what the investor needs.
You will look at how buying property, term deposits and savings accounts stack up against each other, calculate their returns with simple interest (\(I = Prn\)) and compound interest, and think about the effect of inflation — so you can recommend a sensible plan for real savings, such as $10 000 put aside for the future.
Theory
Comparing investment strategies is part of the Investment topic in Year 12 Standard 1 (NSW). A savings account, a term deposit and buying property each trade off return, access to your money and risk. This guide shows how to calculate and compare the returns and recommend the strategy that suits the investor.
A savings account lets you take money out at any time. It is low risk but usually pays the lowest rate, and the rate can change. Interest added to the balance compounds. If a question says simple interest, use \(I=Prn\) instead — always use the method the question states.
A term deposit pays a fixed rate agreed in advance and guaranteed for the term. It is low risk, but the money is locked away, often with a penalty for taking it out early. Buying property can give the highest growth, but the return is not guaranteed, the value can fall in a bad year, it is slow to sell and there are large upfront costs such as stamp duty and agent fees. It has the highest risk.
The best strategy is the one that matches the investor's needs. If the interest rate is below the inflation rate, the money's buying power falls. In this Year 12 Standard 1 (NSW) topic you calculate returns with \(I=Prn\) and \(FV=PV(1+r)^n\) and compare options.
| Strategy | Return | Access to money | Risk |
|---|---|---|---|
| Savings account | low, can change | any time | low |
| Term deposit | higher, fixed and guaranteed | locked for the term | low |
| Buying property | highest possible, not guaranteed | slow and costly to sell | higher |
A term deposit is usually calculated with simple interest (unless the question says it compounds), which earns the same interest every year:
When interest is added to the balance, or a property's value grows by a percentage each year, the growth compounds:
For a compounding account the interest earned is the growth in value:
How to compare investment strategies
- Identify the amount \(P\), each rate \(r\) (as a decimal) and the time \(n\) for every option.
- Choose the formula: \(I=Prn\) for simple interest, \(FV=PV(1+r)^n\) when interest or growth compounds.
- Compare the interest or final values, subtracting to find how much more one option earns.
- Recommend the option that suits the investor, considering return, access to the money and risk.
Use \(I=Prn\) with \(P=8000\), \(r=0.045\), \(n=2\).
| \(I\) | \(=\) | \(Prn\) |
| \(\) | \(=\) | \(8000 \times 0.045 \times 2\) |
| \(\) | \(=\) | \(360 \times 2\) |
| \(\) | \(=\) | \(720\) |
The term deposit earns \(\$720\) interest.
Work out the interest for each, then subtract.
| \(\text{Savings: } I\) | \(=\) | \(12000 \times 0.025 \times 3 = 900\) |
| \(\text{Term deposit: } I\) | \(=\) | \(12000 \times 0.04 \times 3 = 1440\) |
| \(\text{Difference}\) | \(=\) | \(1440 - 900 = 540\) |
The term deposit earns \(\$540\) more interest.
Growth is on the growing value, so use \(FV=PV(1+r)^n\).
| \(FV\) | \(=\) | \(650000(1+0.06)^2\) |
| \(\) | \(=\) | \(650000(1.06)^2\) |
| \(\) | \(=\) | \(650000 \times 1.1236\) |
| \(\) | \(=\) | \(730340\) |
The unit is expected to be worth \(\$730\,340\). Risk: the \(6\%\) growth is not guaranteed, and the value could fall in a bad year.
Find the interest for each option.
| \(\text{A: } I\) | \(=\) | \(9000 \times 0.04 \times 2 = 720\) |
| \(\text{B: } FV\) | \(=\) | \(9000(1.03)^2 = 9548.10\) |
| \(I\) | \(=\) | \(9548.10 - 9000 = 548.10\) |
| \(\text{Difference}\) | \(=\) | \(720 - 548.10 = 171.90\) |
The term deposit earns \(\$171.90\) more, but the savings account lets Josh take money out at any time if he needs it.
Common pitfalls
Frequently asked questions
What is the difference between a savings account and a term deposit?
A savings account lets you take money out at any time but usually pays a lower rate that can change. A term deposit pays a fixed, guaranteed rate for an agreed term, but the money is locked away and there is often a penalty for taking it out early.
Is buying property a good investment?
Property can give the highest growth over time, but the growth is not guaranteed and the value can fall in a bad year. It is slow to sell and has large upfront costs such as stamp duty and agent fees, so it is the highest-risk of the three strategies.
How do you calculate interest on a term deposit?
Most term deposits use simple interest, I = Prn. For example, $8000 at 4.5 percent per annum for 2 years earns 8000 times 0.045 times 2, which is $720.
How do you compare two investments?
Work out the interest or final value for each option over the same time, then subtract to see how much more one earns. Then think about access to the money and risk before making a recommendation.
What happens if the interest rate is lower than inflation?
If the interest rate is below the inflation rate, prices rise faster than the savings grow, so the money buys less than before even though the balance has gone up.