Coincidentally, I received the following two questions less than five minutes apart:
You signed my book at the ING DIRECT cafe in Chicago some time ago. In your book you refer to an 8% savings rate in hypothetical scenarios in several places. Where/how does one get this rate? I have a high interest account (under 2%) at ING DIRECT. I’m considering seeking financial advise/money management at Charles Schwab, but thought I’d check w/you first to get any feedback. I have $60,000 that I think I should be able to grow at a better rate with little (or no) risk, but not in a cd. I’d like to buy my first home in 6 months (with most of this money as a down payment) and am wondering what options I have to safely grow this money. I’m saving maybe $3,000 a month. I’ve never invested. Thoughts?
– Becky B., Chicago, Illinois
I’m thinking of buying my first house some time in the next 4-5 years. And I know I should start saving now. But what is the best way of saving? Should I put my money in a High-Interest Savings account such as ING DIRECT, in a 3-year long CD, or invest in a mutual fund with Vanguard? How do I choose which is the best option? Thank you.
– Diana C., Los Angeles, California
Straightforward Answer: Your investment choices must match your time horizon.
More Detailed Explanation:
Whenever you choose save a dollar, you must choose how to invest it.
You: No, I could put it in the bank.
Putting your money in the bank is an investment decision. It’s called investing in “cash.” Broadly speaking your investment choices are:
- Cash (includes savings accounts, checking accounts, money in your wallet, and change in the couch).
- Fixed Income (includes savings bonds, municipal bonds, corporate bonds, and the stable value option at your retirement plan)
- Equities (includes stocks)
You: What about mutual funds?
Mutual funds can fall into any of the three categories above.
You: Even cash?
Absolutely. A money market fund is actually just a mutual fund that is invested in ultrasafe assets like “cash and cash equivalents.” Furthermore, some mutual funds invest in more than one category.
You: They can do that?
Sure. A balanced fund, for example, will often have a large percentage invested in both fixed income and equities.
Your Risk Tolerance, Time Horizon, and Investment Choices
As covered in depth in the investing chapter of Beyond Paycheck to Paycheck, your risk tolerance should drive your investment choices. (Unfortunately, that’s often not how it works since choices are often revealed to having made:
- Out of fear of losing it all and therby keep it all in the bank – also known as the “Depression Mentality”
- Out of fear of missing out on the next good thing and thereby purchasing 17 condos in Miami, putting $1,000 down per unit.
But that’s a post for another day.
Your risk tolerance is based on both your personality and your time horizon. Both Becky and Diana have shared with us their time horizon as 6 months and 4-5 years respectively. Let’s first address Becky’s conundrum.
Becky Wants 8% And Has a 6-Month Time Horizon
Turns out Becky isn’t going to be happy.
Because she has two mutually exclusive objectives. The first is to earn an 8% rate of return on her money. The second is extreme safety for her money since she needs it for a home down payment in just 6 months.
You: Why can’t she have these two goals?
She can. Just not at the same time on the same money. In order to expect to earn about 8%, she’ll need to take the risk of investing her funds in the stock market. (For those of you skeptical that 8% is achievable or that it dramatically understates today’s opportunity, I say:
I really don’t know what’s going to happen in the near term and neither do you.
However, 8% is the long-term historical return of the stock market (Check out this cool little calculator at Money Chimp where you can plug in any pair of start and ending years and learn the historical performance of the S&P 500). Since 1900, we’re at over 9%. Since 1990, we’re still over 7%.) Indeed, even today 8% seems reasonable for long-term performance.
You: But what’s the big takeaway?
There’s a ton of volatility in the stock market.
You: Well, there’s a newsflash.
First off, to some people it is. And secondly, when times are good (which they will be again), many people forget about the risk. Or, more precisely, they redefine risk as “not making as much money as someone else did.” All along, in good markets and in bad, you can make money and you can lose money by investing in stocks.
The net impact to Becky is that no matter how aggressive she is (and she’s probably not that aggressive, being that she’s accumulated $60,000 and has “never invested,”) she must keep all of her down payment money in cash. That’s the only way to ensure she will absolutely have her money available to her when she needs it six months from now.
Only in a savings account or a money market fund can she be assured that she won’t lose her principal. Furthermore, only cash affords her the ability to refrain from timing the market. After all, where will the stock market be in six months?
You: I don’t know.
Me neither. You wouldn’t want to have to sell if we’re back down at 6,500, would you?
You: No. will it be back to 6,500 again?
I still don’t know.
You: Me neither.
I think you see my point.
You: Right. So Becky can’t get 8% without risking her principal?
Correct – and please don’t comment below about the sure thing in soybeans.
Gary: It’s actually frozen orange juice.
Becky, just keep your money in a high-interest savings account and you’ll be fine. If you’re absolutely certain you won’t need it for six months and you can get a better rate with a CD, feel free, but remember the first time home buyer tax credit. If you’d otherwise buy a house in December, buy it in November and get the free $8,000 (subject to income restrictions).
Diana Has More Time – Can She Take More Risk?
Diana’s time horizon is a bit longer: 4 – 5 years. But, from reading her letter, her risk is less so from a potential loss of principal than it is from a current lack of savings. Diana needs to get going on savings for this specific goal (a home) today. It takes along time to get a down payment of 20% of the price of the home in order to avoid costly and utterly unnecessary PMI – especially in California.
You: Why is PMI unnecessary? I thought it was required if you put down less than 20%.
It is required. It’s unnecessary because no one is putting a gun to your head saying buy a home you can’t afford to pay 20% down on.
But nothing. Save longer or buy a less expensive home. Or, like Diana and Becky, start saving well before you actually go home shopping.
You: When Diana starts saving, where should she put her money she has earmarked for a home?
In the bank.
You: She shouldn’t invest in stocks?
You: Why not?
Because the risk of loss of principal is still too great.
You: But if the next three years prove to be stellar for the stock market, this would prove to be the wrong advice.
No, it would prove to be unlucky. It’s the right advice for that very reason: we simply don’t know. Many people have advocated investing in stocks for your long-term objectives like retirement. Count me among them. From my vantage point, stocks make sense for my retirement plan as much today as they did 15 years ago when I started investing. I still felt that way earlier this year when the Dow was down in the mid 6,000s.
Don’t get me wrong, it may have periodically caused some lower intestinal distress, but it was and is still the best way to go – for the long-term.
You: What’s long-term?
At least 10 years. Four or five years is just too short. Diana, put your money in something much safer. A CD (or more than one CD) could be attractive, but you shouldn’t be investing your home money in anything you could actually lose your principal by in. By definition, this includes stocks.
More aggressive and sophisticated investors could consider bond or other fixed income investing – but given where we are with interest rates at the moment, even those may prove to be overly risky – especially for someone new to the game.
All of this leads to a wonderful conclusion: savings will be the primary determinant for you getting you your first house someday. True discipline will give you the opportunity to become a homeowner and in a far different way than the buyers of 2005 and 2006 accomplished the feat.
Remember, however, do not be cheap – be fiscally responsible.
I’m beginning to go through the home buying process myself. When you call your banker and you tell them you’re going to be putting down 20% (or more) and they pull your impeccable credit history, you will feel rewarded when they tell you what you can afford and at what rate. This is the future for Becky and Diana.
You: And me?
That’s up to you.