Welcome to the third post in the Investment Series. For those just joining us:
Article 1 told you why investing in stocks is actually pretty simple, and
Article 2 described the volatile nature of stock returns.
So we’ve established that while long-term stock market returns have been quite predictable for over 100 years, with an after-inflation return of over 7% per year, we’ve also noticed that they fly up and down in an absolutely random manner in the short term. And “the short term” can actually mean periods of up to 15 years.
So: for long-term savings, like the money you are saving in 401(K)s, Roth IRAs, Canadian RRSPs and such, stocks are still the best balance of large long-term gains versus risk. You’ll see some alarming swings if you check the stock prices every day, but if you just open up your statement on the day you turn 59.5 to start your withdrawals, you will probably be pleasantly surprised.
What about money you need for more immediate needs? Say you are saving for a house downpayment that will take two years to accrue. Or you received a gift from your grandma to pay for your college education, but you won’t even be graduating from high school for three years. Here is a list of investment types and their current approximate return rate, listed in order from safest to most volatile (and most rewarding over time):
- Bank Accounts: the best I know of is ING Direct Orange Savings account – still only 1.0% right now. Checking accounts don’t deserve ANY of your money – enough to handle the monthly automatic-bill-pays only.
- Money Market Funds (such as Vanguard’s Prime Money Market Fund) have historically delivered higher returns than savings accounts but not with today’s lowest-in-history interest rates. Less than 1.0%, so skip ’em for now.
- Certificates of Deposit – where your money is locked up for a specified time period in exchange for more return. I just copied the following rates for today from bankrate.com/cd.aspx
|1-year CD||1.31% APY ($1000 min. balance)|
|3-year CD||2.00% APY ($500 min. balance)|
|5-year CD||2.75% APY ($500 min. balance)
- And, of course, the best guaranteed no-volatility place to invest your money may be paying off existing debt. Your mortgage, your student loan, or if you still have superbad loans like car or credit card debt, you need to get on those, emergency style, before you consider saving for anything else.
As I suggested in an earlier article called “springy debt instead of a cash cushion“, until you are completely debt-free it may make sense to use a line of credit as your cash cushion instead of short-term savings. Because which one makes more sense: saving for an upcoming purchase in a 1.0% bank account while simultaneously paying 4.5% on your mortgage, or putting all the short-term money into the mortgage and just borrowing back whatever you need at 3.25% in the form of a line of credit? Another reason I like this approach is that it reminds you that until you are mortgage-free, you are effectively borrowing for everything you buy. Not necessarily bad, but it is good to be reminded of this when you’re at the pub deciding whether or not to spring for another pitcher.
Medium Volatility/Medium Returns
- High-quality corporate Bonds: These have recently delivered a 4-5% return and yet are much less jumpy than stocks. Take a look at the ten-year performance of a suitable Vanguard Bond fund (VFSTX) compared to my favorite big US index fund (VFINX):
After looking at that 10-year comparison, you might wonder “why would anyone buy stocks when the bonds do so well?”. The answer lies in the longer term. Since its inception in 1976, the stock fund has compounded at 10.72%, while the bond fund (started in 1982) weighed in at only 6.99%. Over a 30-year period, a single $100,000 invested in stocks would have become $2.1 million, meanwhile a bond investor would only have $759,000. Still, for 1-3 year savings with a still-reasonable return, I’d feel fairly happy with the bond fund myself.
- Mixed Stock/Bond Funds: Vanguard’s VBINX is a mixture of 60% large company stocks and 40% investment-grade bonds. In bad markets, it is safer than VFINX. In good markets, it underperforms the pure stocks.
For someone like me who wants a growing-but-semi-stable pool of money to use up over the next 5-10 years, a mixed fund can be a good choice. I can leave my long-term “old-man” money in stocks, but keep 5 years of living expenses in a mixed fund like this, and automatically make monthly transfers to the checking account to fund regular living. In the event of a stock market crash in the long-term investments, the VBINX takes a much smaller hit and thus principal is preserved. Then I could wait at least 5 years for a recovery in the main market before topping up this fund again.
Hint: If you want to do a little fund shopping of your own, you can play with the same web site I used to generate the graph above. Start here and then start clicking around on fund types, or type a fund symbol into the box. Then you’ll see a “growth of $10,000” tab which will get you into the nice charts.
In all cases, do your own math on short-term savings and figure out how much you expect to earn from the investment. If you’re just saving to buy a tricycle for your daughter next month, or a $5000 used car in three months, there is not much benefit in worrying about investment returns.
Also remember that the more you cut your spending in general, the faster your savings accrue, meaning you don’t have to think about saving as much. Some dual-income families need to plan months ahead even for a new washing machine, while their Mustachian counterparts could buy an entire car with less than a month’s notice, and the only effect would be that they would pour less into their long-term investment accounts that month. This flexibility and convenience makes your life much simpler and happier – yet another reason frugality rules.