Photo (cc) by 401(K) 2012
Interest rates are a double-edged sword. With the exception of credit cards, rates to borrow are extremely low. Mortgage rates, for example, are as low as they’ve been since the end of World War II. So, if you’re a borrower, it’s all good. But if you’re a saver, it’s all bad. Rates on savings accounts are so low they’re practically zero.
What’s a saver to do? Here’s a question from a reader.
How are middle-class Americans supposed to get ahead? Wages aren’t going up, but gas and food prices are. And the money banks are paying on their savings accounts are nothing. I’d like to try other kinds of investments, like stocks, but I’m afraid of risk. Is there anything I can do that to earn more without losing money? Please tell me what to do.
I feel your pain, Dave. Compounding your savings by earning interest is critical to getting ahead. But the interest on savings accounts is doing the same thing as wages: going nowhere.
One alternative to crappy bank interest is stocks, but stocks involve risk. And while stocks and risk have always gone hand-in-hand, today it’s even worse for at least two reasons. First, the European debt crisis could ultimately hurt our economy, and in turn, our stock market. And second, the inability of the U.S. Congress to agree on anything from debt reduction to stimulus could also have a negative impact on our economy and stock market.
Nonetheless, every saver should always have some money in investments other than risk-free bank accounts. The reason is simple. Risk-free investments rarely keep up with inflation over time. And maintaining the purchasing power of your savings by earning more than the rate of inflation is the prime directive.
For a 90-second primer on investing, watch the following news story I shot on the floor of the New York Stock Exchange. We’ll continue the conversation on the other side.
To recap those tips:
- Don’t ever put any money into stocks that you could possibly need within five years. The longer your time horizon, the lower your risk.
- Don’t put all your eggs in one basket. If you can’t afford to own stock in at least 10 different companies, use a mutual fund or Exchange Traded Fund. That way you own a sliver of lots of different companies rather than just one or two.
- Don’t invest in stocks all at once. Invest small amounts monthly. That way, should the market fall, you’ll have money on the sidelines to buy at lower prices.
- To decide how much to put in stocks, here’s your rule of thumb: Subtract your age from 100 and that’s the percentage you might want to put in stocks. So if you’re 25 years old, you’d take 25 from 100 and put that amount, 75 percent, of your long-term savings into stocks. If you’re 75 years old, you’d only take that kind of risk with 25 percent of your savings. But remember, this is a rule of thumb. If you’re going to freak out when the market falls, invest less.
What should you buy?
Regular mutual funds: The idea behind mutual funds is pooling money from lots of investors to buy a large, diversified portfolio of stocks. And as I said above, it’s safer to own a sliver of a giant group of stocks than a bigger chunk of just one or two. One fund to consider is the Vanguard 500 Index fund. As the name implies, it owns the shares of 500 of the largest companies in America. The minimum investment is $3,000, but it costs nothing to buy or sell shares in the fund. There is an annual management fee, but it’s only 0.17 percent – pretty small for a mutual fund. The fund, like the stock market overall, hasn’t done well over the last 1, 5, or 10 years. But it’s averaged better than 10 percent per year since its inception in 1976.
Once you open a mutual fund account, you can have money automatically added every month by linking it to a bank account.
ETFs: An Exchange Traded Fund, or ETF, is just a mutual fund that trades on an exchange like a stock. Here are two that allow you to get a lot of diversification: The Vanguard Total Stock Market ETF invests in 3,000 U.S. stocks. As I wrote this, the cost per share was about $65, so that would be your minimum investment: 1 share.
If you’d like to invest internationally, check out the Vanguard Total International Stock ETF (VXUS). This ETF is currently trading around $40 a share.
The disadvantage of an ETF is that to buy shares, you’ll need to open a brokerage account and pay a commission with every transaction. And even if you use a discount broker (I use Vanguard as my brokerage firm, but there are plenty out there) you’ll still pay at least a $5 commission every time. While that may not sound like much, if you’re only investing $100 a month, that’s 5 percent off the top. Here’s a site that has commission prices and reviews on lots of brokerage firms.
By the way, if you’re wondering why my recommendations are all Vanguard-related, rest assured that’s not because they pay me. Other than having a brokerage account there, I have no relationship with them whatsoever. I recommend them exclusively because they’re one of the lowest-cost players in the business.
Conclusion: Don’t expect miracles
I wrote this post in answer to a question regarding earning more than banks. Over time, stocks have done this. And the difference it can make on your savings is remarkable.
Let’s say you find yourself with an extra 10 bucks a day, or $300 a month. If the only thing you do is put your savings in a 1-percent money market account, after 20 years you’ll compound your way to a balance of $80,000. Nice. But if you earn 10 percent instead of 1 percent, your nest egg will increase to about $228,000. Way nicer.
I’ll end this post with the same analogy I started it with: the double-edged sword. Stocks pay more over time because they’re riskier. While they can go up, they can go down, and by a lot. They can also go sideways, which is what they’ve done for the better part of the last decade. So don’t expect instant results. Over the long-term, stocks will help conquer inflation. But over the short term, there’s no telling.