Investing can feel overwhelming with so many choices, but fixed term deposits and exchange-traded funds (ETFs) are often popular contenders. Each offers something different – whether it's the safety of guaranteed returns or the potential for growth through the share market.

In this article, we'll explore how fixed term deposits and ETFs compare. You'll learn about their features, risk levels, and what to consider when choosing between them. Whether you're looking for stability or growth, understanding these two options can help you make an informed decision.

What are fixed term deposits?

Fixed term deposits are a simple, theoretically low-risk way to invest your money with a bank. You deposit a set amount for a fixed period, and the bank guarantees an interest rate throughout that time.

The interest rate stays locked in, no matter what happens in the market. Terms can range from a few months to a few years, but your money is tied up until the term ends.

Fixed term deposits can be great for investors who want to protect their savings. They offer potential stability but usually lower returns compared to other investments, like exchange-traded funds (ETFs). They’re often used when you want to keep your money safe, especially for short-term goals.

Before jumping into a fixed term deposit, think about how long you can commit your money and whether the interest rate meets your needs. These details can help ensure you’re making the right choice for your financial situation.

What are ETFs?

Exchange-traded funds are investment funds you can buy and sell on the stock exchange , just like individual shares. ETFs are designed to track the performance of a specific index, sector, or asset class, which gives you exposure to a variety of investments all at once.

There are different types of ETFs, each offering a unique way to invest:

• Equity ETFs: These invest in shares from a specific index, like the ASX 200 , giving you broad exposure to the stock market.
• Bond ETFs : Focus on bonds, providing a way to invest in fixed income assets for more stable returns.
• Sector ETFs: Target specific sectors, such as technology or healthcare, allowing you to focus on industries you believe in.
• Commodity ETFs : Invest in commodities like gold, oil, or agricultural products, which can help diversify your portfolio further.

ETFs vary in risk depending on what they invest in. Some seek to offer stable returns, while others track more volatile markets, meaning higher potential gains but also higher risk.

An investor might choose to invest in an ETF for different reasons. These include diversification; cost-effective investing; access to specific markets or sectors; and income generation.

Key differences between fixed term deposits and ETFs

Choosing between fixed term deposits and ETFs comes down to understanding how each fits into your financial strategy. While both have their place, they serve different purposes, depending on your goals and risk appetite.

1. Risk level

Fixed term deposits tend to come with very low risk because your principal and interest are guaranteed. ETFs expose you to market risk , meaning the value can fluctuate with the stock market or asset class they track. While fixed term deposits provide stability, ETFs carry the possibility of both gains and losses.

2. Return potential

Fixed term deposits offer fixed income agreed upon when you invest, but these returns are usually lower compared to other options. ETFs have the potential for higher returns over the long term, depending on market performance. However, these returns are not guaranteed and can vary widely.

3. Liquidity

Fixed term deposits lock in your money for a specific period – typically ranging from a few months to several years. ETFs are more liquid. You can buy and sell them on the stock exchange during trading hours, making it easier to access your money if needed.

4. Diversification

With fixed term deposits, you’re investing in a single product, meaning there’s no diversification. ETFs, by design, offer instant diversification by spreading your investment across multiple assets, such as shares, bonds, or commodities. You can also invest in ETFs spread across sectors or geographies. This diversification can potentially help manage risk.

5. Fees and costs

Fixed term deposits are straightforward to invest in. There are little to no fees involved, except for penalties if you withdraw early. ETFs can come with management fees, trading costs, and other potential expenses, depending on the ETF type and trading platform.

6. Tax treatment

Interest earned from fixed term deposits is generally taxed as income, as is income from ETFs (also known as dividends). Some ETFs may have franking credits attached to them which can offset taxes and be a benefit to investors. ETFs that are held for more than 12 months may be eligible for a capital gains discount. For more insight into your specific tax situation, speak to a licensed tax accountant.

These differences show how fixed term deposits focus on security and stability, while ETFs offer flexibility and the potential for higher returns with added risk. The right choice depends on your goals, risk tolerance , and investment timeline.

Performance under different market conditions

Bull markets (rising markets)

A bull market occurs when asset prices rise, typically driven by economic growth and investor optimism.

• Fixed term deposits remain unaffected by market growth. While you get guaranteed returns, they might seem limited compared to potential market gains. Note that in a rising market, fixed term deposits won’t generate higher returns than the fixed interest rate.
• ETFs can perform well in bull markets, especially those tracking shares or growth sectors. As prices rise, ETF values can increase, offering potentially higher returns. But remember that past performance doesn’t guarantee future results. Markets may shift, so these gains aren’t certain.

Bear markets (falling markets)

A bear market is when asset prices decline, usually due to economic downturns or investor pessimism.

• Fixed term deposits generally offer safety in bear markets. Your capital is secure because you’ll receive a sure return, regardless of market drops.
• ETFs can lose value in bear markets, particularly those tied to shares or volatile sectors. Investors may face short-term losses as prices fall. As mentioned, ETFs carry market risk, and performance can drop significantly in a downturn. However, ETFs may recover long-term, though no returns are guaranteed.

High inflation environments

Inflation reduces the purchasing power of money, as prices for goods and services rise.

• Fixed term deposits might struggle to keep pace with inflation. The interest is fixed, and if inflation rises, the real return on your investment could be negative.
• ETFs can potentially outpace inflation, especially those that include assets like shares or commodities, which may rise with inflation. Keep in mind that ETF performance varies widely. While they may protect against inflation, there’s no certainty of returns, and losses are possible.

Low interest rate environments

Low interest rates are typically used by central banks, like the Reserve Bank of Australia (RBA) , to encourage economic growth.

• Fixed term deposit rates are generally low in such environments, leading to smaller returns. That means your investment grows slowly, which might not meet your financial goals.
• ETFs might benefit from low interest rates, particularly those tracking growth sectors that can borrow more easily. However, performance depends on market conditions and volatility remains a factor.

Case studies – fixed term vs ETFs

To illustrate how fixed term deposits and ETFs might work in practice, let’s look at two fictional investors, noting that individual results can vary. These case studies are not predictions, but examples to help inform your decision-making.

Case study 1: Emily's conservative approach

Emily prefers stability over high returns. She chooses a fixed term deposit for her $20,000 savings because she wants guaranteed interest. Over three years, she earns 2.5% per year. By the end of the term, she knows exactly what her balance will be, without any surprises from market changes. Emily values security, but her fixed return doesn’t keep up with inflation, so her purchasing power slightly declines. This case study offers just one scenario for Emily’s investment; a low inflation environment could have maintained her purchasing power.

Case study 2: Oliver’s growth focus

Oliver is aiming for long-term growth and chooses a diversified ETF that tracks the ASX 200. He invests $20,000, expecting higher returns over 10 years. The market rises in some years but drops in others. After 10 years, his investment grows by an average of 6% per year. However, there were periods when the value dropped, and Oliver had to accept short-term losses before seeing growth again. Oliver’s 10-year investment period could have coincided with more bull markets than bear markets, offering a favourable scenario. This is just one of many potential performance scenarios when investing in an ETF.

These case studies show how different strategies might suit different goals. Emily prioritised security with a fixed term deposit, while Oliver took on more risk with ETFs for potential long-term growth. Both approaches have their potential pros and cons, depending on the investor's financial needs and risk tolerance.

How to choose between fixed term deposits and ETFs

When deciding between fixed term deposits and ETFs, it’s essential to reflect on your personal financial situation, goals, and risk tolerance. Both options have their benefits and drawbacks, and what’s right for you depends on what you’re aiming to achieve.

Here are some key questions to help guide your decision:

• What’s my risk tolerance?
  If you prefer stable, guaranteed returns, fixed term deposits may suit you. If you're open to more risk for higher growth potential, an ETF might be better.
• How long can I invest my money for?
  Fixed term deposits require you to lock your money away for a set period. If you need more flexibility, investing in an ETF can allow you to buy and sell anytime.
• Am I looking for growth or stability?
  If capital growth is your goal, ETFs can provide market exposure with the potential for higher returns. For stability, fixed term deposits offer fixed returns.
• Do I need regular income from my investment?
  Some ETFs aim to provide regular dividends or interest. Fixed term deposits provide interest, but typically at the end of the term, unless otherwise specified.
• Do I want diversification?
  ETFs can offer you easy diversification by investing across a range of assets, industries or countries. Fixed term deposits are focused on a single deposit, without any diversification.
• Am I concerned about inflation?
  As mentioned, ETFs can potentially outpace inflation over time. Fixed term deposits may struggle to keep up, particularly if inflation is high.

It’s also worth considering that you don’t have to choose one over the other. Depending on your financial goals, you might decide to invest in both for a diversified approach. You may want to keep some money in fixed term deposits for stability and security, while investing in ETFs for long-term growth.

Alternatively, you might find neither option fits your current needs, and that’s perfectly fine too. The most important thing is that your investments align with your financial goals and risk tolerance.

Fixed term deposits, ETFs, or both?

Fixed term deposits and ETFs can each have their place in a well-thought-out investment strategy. Fixed term deposits are about stability and guaranteed returns to potentially keep your money safe. ETFs offer more growth potential and diversification, which can boost your long-term returns.

So, which is right for you? It comes down to your goals and how much risk you’re comfortable with. You don’t have to choose just one – many long-term investors use both to get the best of both worlds.

At the end of the day, it’s all about making sure your investments fit your financial plan and give you confidence for the future.