Savings can provide a backbone and some much-needed stability for your financial future. But savings alone in the form of short-term investments aren’t everything. It’s necessary to plan for future needs as well. To do that, you must get your money to work harder for you. Here are some approaches to do exactly that.
The Connection Between Interest and the APY
Interest return for savings is critical. Otherwise, you will lose money to inflation (where the cost of living rises every year). Depending on the CPI, savings must increase in value to at least cover inflation, otherwise you’re losing ground. Let’s say that the APY on a savings certificate is 3%. With compounded interest, the APY can be calculated easily with an online tool. Therefore, if you find that the CPI is 2%, then your money is growing 1% above inflation (3% APY minus 2% CPI). You’ve achieved a 1% real return (above inflation) on savings.
While savings plans and investments are quoted in ‘nominal’ terms – meaning the gross return – with investments, there will be fees to deduct, and sometimes commission too. Astute wealth builders consider this to know how fast their invested capital is really growing.
Getting a Good Short-term Return
Money that’s needed within the next few years shouldn’t be tied up in long-term investments. While they sometimes offer attractive rates of return, they can fall precipitously over a 1-5-year period. Putting money into these offers the chance of significant loss, which is not worth it in pursuit of a 1-2% advantage.
Look for FDIC-insured accounts that don’t lock your money up for too long. Also, consider Certificates of Deposit from U.S. banks for a one-year lockup of the savings in exchange for a higher interest rate. Find a balance between cash that still must be quickly accessible versus savings that won’t be touched for at least a year. This way, you can get a higher blended APY on cash balances.
Bonds for the Adventurous
Bonds are a form of loan either from a government or a corporation. They come with a rating from an agency to confirm their creditworthiness. It confirms their likelihood of covering the interest coupons and repaying their value at the end of the term. It’s possible to purchase individual U.S. government bonds. However, for people new to bond investing, it’s easier to invest in a bond index fund. One example is the Vanguard Total Bond Market Index Fund that invests across the whole bond market, not just government bonds. At the time of writing, the trailing twelve-month yield is 2.08% with a yearly expense ratio of 0.15%.
Ten Years and Longer Investments
Longer-term savings can work harder when they’re going to be untouched for many years, e.g., for possible retirement or toward a distant savings goal.
While you can pick an actively managed mutual fund, most fund managers fail to beat an index fund over the duration. Because of this, sticking to index funds enjoys a lower cost and a greater likelihood of success.
The T. Rowe Price Total Equity Market Index Fund, for instance, provides broad coverage to the equity market and comes in at just 0.30% in annual fees. While you cannot guarantee results, being long on equities for long-term investments offers the potential to grow capital beyond the fees and drag of inflation.
Putting money into real estate funds, oil pipelines, timberland, or private businesses are other possibilities. Beware of these kinds of deals. Extensive research and an understanding of the particular asset class are needed to be sure before investing. These investments tie up capital for many years – often decades – with their outcomes difficult to predict. While you cannot know how bonds or the equity market will perform, when investing via established investment houses like Vanguard, T. Rowe Price, and Fidelity, you’re in safe hands.
Avoid Reaching for Higher Yields
Especially for short to medium-term savings, people can make the mistake of reaching for a higher yield. While obtaining the best yield is sometimes beneficial, avoid putting short-term savings into riskier situations. While the yield on a CD or money market account may not be wonderful, the funds that you’ll need will still be there in a few months, whereas when you get into high-yield bond funds or other riskier investments searching for more income or capital gains, the risk is often ignored until it’s too late.
When correctly assessing what money is available from savings and how long you can tie it up for, then deciding where to place it is the easier choice. Always consider the risk as well as the APY, because things aren’t always as they seem.