Welcome to the first installment of the Friday Q&A series which I hope to make a regular feature. I often get specific questions by email or on internet forums that I know other people out there have. I'll try to use them (obscuring personal information obviously) for your education.
Question:
I have about 100k sitting in a savings account for a down payment on a house for when I do eventually move. I don't know when a spot will open up [in this group I'm hoping to join.] I imagine it could be anywhere from 6 months to 3 years. I know I should at least put the money into an online savings account, but is there something that would be better, like some type of short term bond fund at Vanguard? I know I obviously don't want it near the stock market.
Answer:
It's all about the risk/reward ratio. You can't expect more than about 1% risk-free. I think my Ally Bank savings account is paying 0.95%. That's where I keep my emergency fund, but I might need that tomorrow. You could buy Ally's CD that has no penalty for early withdrawal, but it only yields 0.92%. They'll give you a 2 year “raise your rate” CD at 1.14%.
You might consider taking some risk with the money in hopes of a higher yield. Perhaps you could put 1/3 of it into an Ally Savings account, 1/3 into a lower risk bond fund such as Vanguard's Short Term Investment Grade (corporate bonds) Fund which has a current taxable yield of 1.47%, and 1/3 into a riskier bond fund such as intermediate term bond index (yields 1.88%) or even a stock fund like Total Stock Market.
Obviously, once you get out of the guaranteed investments you not only have to worry about the return on your principal, but the return of your principal too. Your choice, but risk and (possible) return are linked. It's possible (although fairly unlikely) that you could need the money at a time when bonds have lost 10% of their value and stocks have lost 50% of theirs.
Good luck with your decision. There's nothing wrong with just leaving it in your checking account too. I mean, think about it. 0.95% of $100K is only $950 over a year. You're not exactly leaving a ton of money on the table.
Agree? Disagree? Post your thoughts on how much risk to take with your short term savings in the comments section below.
Image Credit: Kalan, via Wikimedia, CC-BY-SA
I wonder if we were in a high interest rate environment if people would have the same concerns?
If you really need the money for either an emergency or some purchase that could be in the near term, i personally think people should just be satisfied with the low return of their bank account. Getting to fancy typically gets people into trouble.
I agree 100%. For needs that could almost be immediate, I would stick with a bank account or money market fund with checkwriting ability.
I was really surprised when I called the 800-number at my big brokerage and put the same question to them and got the same answer. I thought for sure they would try to sell me an actively managed short-term bond fund or similar. Of course, they did tell me to just keep it in their money market account, which is paying 0.01% interest and is not FDIC insured.
I’m not satisfied with zero rates. There aren’t any easy ways to get more interest, but it can be done.
There are different investments that can fit the bill here. I have a few ideas here but i suggest that you learn about them to get comfortable. (it took me some time to get to the point to put major money in them). I use these investments to park money until I find other investments to buy (which can take some time).
You can get a little more interest if you go with short to intermediate term bond funds. There is a downside here, the stated interest rates of these will be higher than their actual yields (referred to as yield to maturity). This is due to the fact that in this interest rate environment, the bonds might have been bought over par value. They should still be higher than money market funds. Here’s a post that talks about a short term laddered bond fund CLF: http://www.dividendninja.com/recent-buy-clf-bns-and-ry
To get more interest I am going with another kind of debt.
Where you need to be right now is in the low investment grade or near investment grade corporate debt. If you go with the high quality stuff you open yourself up to interest rate risk (this will be a problem in the future, though, maybe longer than anyone thinks. )
Typical corporate debt is either sold in funds or in less liquid individual bonds . You could invest in individual bonds from your broker. I’m personally not a fan of funds and individual bonds require more effort to research and purchase.
There is another type of corporate debt that is very liquid and available to the average investor. They are preferred stocks which trade like stocks and are structured like bonds (pay interest, setup at a par value, but typically have long to unstated maturity). If you don’t want to do any work, you could invest in the ETF PFF. This ETF invests in a basket of preferreds and currently pays an annual yield of 6% ( paid monthly). The price of this preferred has been stable round $40 for the past 3 years.
I’m personally a fan of investing in individual preferreds. In this interest rate environment there has been a slow and steady march by professional managers towards all kinds of lower grade debt (including preferreds). The key to succeeding here is to buy preferreds that are higher quality than what the ratings agencies rate them as.
I recommend that you hold your nose and buy say, Bank of America Preferreds. In my portfolio I have a REIT preferred that pays about annual yield of 6.5% (paid monthly). Here’s a spreadsheet that lists many different ones to buy:
https://docs.google.com/spreadsheet/ccc?key=0Ai6nAWjRjzKlcHh3bzNhOHFJanNFTEdXY3BZMUU5U2c
i took this advice and bought a diverse group of individual preferreds mostly at or below par for my emergency fund and have gotten nice returns and also a nice bump in nav.
I decided to put my emergency fund in small value stocks and am up over 10% already this year. I’m just kidding, but the point is that yes, you can get higher returns on money, but only by taking more risk. If something yields 6% you can be assured that there is greater risk of loss of principal than with an investment yielding 1%.
That’s called reaching for yield. Yes, you can get more yield, but to do so you must take on more risk. Just because the risk hasn’t shown up yet, doesn’t mean it can’t. I’m not saying the questioner can’t take on more risk, just that he should be aware he is doing so when pursuing higher yield investments.
I’m not a big fan of preferreds. Larry Swedroe has made some pretty convincing arguments against the retail investor using them. Here’s a good summary of his arguments. http://www.cbsnews.com/8301-505123_162-57413922/why-you-should-avoid-preferred-stocks/
Don’t forget i bonds. Tax deferred, state tax free, only a three month interest penalty if cashed before 5 years, and interest is tax free if used for educational expenses and your agi is under a varying limit , and keeps up with inflation. The dowside is only you must keep it at least one year (11 months and one day if you time it correctly), there is not going to be a fixed component for awhile, and unless you play games with tax retirns, you are limited to $10,000 electronically per year.
Six
if you want to say many physicians probably dont need much of an emergency fund and thus can pursue a strategy like yours then i wont argue with that but you are taking on a much riskier strategy. You could just as easily invest straight in stocks. The question in this thread is about money that you cant really risk much loss with and is potentially necessary in the short run. In that situation, i just cant agree with your thoughts but again have no problem with the idea that you or others might not need much of an emergency fund. (assuming you have good disability and term life insurance).
What do you recommend using for asset protection for an emergency fund? A $100,000 savings/money market account is a big liability for anyone searching for a reason to sue. With today’s interest rates, I would consider just putting my emergency fund under my mattress (or more appropriately a safe/ safety deposit box). Your thoughts?
A reader emailed this comment in:
Don’t buy a house. It will likely not return your investment factoring in inflation over the long haul with all the expenses of upkeep and remodeling over the life of that mortgage and the vagaries of the real estate market. Rent instead and put that $100k to work in a asset allocation that fits your long-term risk profile.
My humble opinion. Wish I had done that.
That reader could be right. Nobody knows. One could say it adds diversity vs just putting more money into the stock market. I own bc my wife wanted a house. I would have eventually wanted to purchase one im sure. The lower the interest rate one has with the current tax deductions, the more attractive ownership becomes as a long term play. Worse case scenario, you have some place to live in 15-30 years depending on the mortgage. I just wouldnt buy a huge house.
DocB-
Technically your mattress and safety deposit box have to be revealed in court when a judgement is made against you, so that isn’t necessarily an asset protection strategy. Obviously if you’re willing to lie in court there are lots of ways to hide money, some of which probably earn you a better return than your mattress.
how do you know he doesnt have a magic mattress?
Although it has been stable for the last couple years, PFF dropped 60% in 2008-2009.
This money belongs in the bank, or better, a credit union. Since credit unions are non-profit organizations (think “banking co-op”), they pay higher rates on deposits in many cases, and their NCUA protection is as solid as the FDIC protection you get at the bank. If it doesn’t make sense to take out a home equity loan to buy stocks or bonds, it doesn’t make sense to invest your down payment in ar-risk securities either.
So far all the comments are pointing to only one investment solution for this person. Based on the dollar size and variable time line why not invest in multiple areas such as money market, high quality short term corporate bond fund, short term government bond fund, international bond fund, mortgage bond fund and a high yield bind fund. The weightings will likely not be the same for each slice but they all act differently and provide different level of yields and risk. I actually have a post on my site http://www.yourwealtheffect.com that asks the question “are high yield bonds worth the risk”
That’s a reasonable thing to do, but with the downside of added complexity. 6 asset classes for $100K can be a bit of a pain.
Yes six funds take more time than one fund but I prefer to spread my risk across six rather than one and I also believe that the extra income earned over what cash pays is worth the time. 5 percent interest on 100k is 5k per year.