With interest rates this low you might find it difficult to decide where to keep money. But if you approach the question methodically, it’s far easier to make a good decision.
The Purpose is the Key
Some money is meant to be spent or held for an emergency fund. Other money is meant to create income. And other amounts are to be invested. The first question you have to answer in order to know what to do with your money is what the purpose of this particular pot of dough is. Do you need the cash to pay off bills next week? Is for an insurance payment next month? Are you saving up for a down payment on a house in a few years? Do you need to create income from that money? If so, do you need that income now or somewhere down the line?
In short, you need to decide what you need to do with that money and when. Once you answer these questions, the placement decision becomes very easy.
If you need the money within the next 6 to 12 months, stick it in the most convenient bank you can find. Consider how much you are investing and how much trouble its worth. Let’s assume you have $5000 that won’t need for 6 to 12 months. Let’s also assume that you could search high and low and you actually find one bank that is paying a full percent more interest than the competitors. 1% of $5000 is $50. So if you can open that account without too much hassle that would be good. But if the trouble of opening the account is greater than the extra $50 you’ll earn over there, why bother?
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Of course, the more money and the greater the length of time, the more that extra 1% means. Using another example, if you had $5,000,000 rather than $5,000, that extra 1% comes up to a cool $50k. Now we’re talking turkey.
The bottom line is that you should tally up how much money we’re talking about and calculate how much it makes sense to pursue that higher rate.
What if you need to save up for something over the next 5 years? At this point does it make sense to invest? Everyone has to answer this question for themselves of course. But when people ask me for an answer I typically recommend a balanced fund approach. This depends on the size of the investment naturally, but I like having a number of funds that together make up a portfolio that has both stocks and bonds. This is an effort to blend a decent return with some measure of stability. Of course this is not a guaranteed investment. Even though the risk may not be too great with this investment style, the risk is still there. If you can tolerate that risk, I think this is the best approach for many people.
When you are talking about money that you won’t need for 5 or more years, I suggest a portfolio that emphasizes growth. Of course there is more volatility with this strategy but so what? Your long term goals need to be matched with long term investments if you want the best potential return. Look at the chart below. It shows that there is a great deal of volatility with a stock investment in any one year. Over the last 60 years, you might have earned as much as 51% in any one year – or lost as much as 37% in one year. That’s a great deal of risk. But if you average out those returns over a five year period, you can see that historical returns of an all-equity portfolio are more acceptable. Of course the past is no guarantee of future results. But over the last 60 years, there was never a 20 year period where the SP 500 lost money for investors.
There are a variety of ways to select the right mutual funds and/or investment style. And it’s very important to stick to your investment strategy once you’ve decided on an approach. But given the trade-offs a strategy that includes a focus on equity growth makes most sense for people who want to achieve their financial goals over a longer period.
The bottom line is that there are tradeoffs to every financial decision you make. If you need short-term access and liquidity, put your money in the bank. As your time horizon expands, consider putting a greater percentage of your assets into growth equity funds. This choice does expose you to short-term volatility but it also provides the greatest potential return historically.