Where can I invest my money that earns more than my savings account?
I have several clients that are saving for a down payment on house, and they all want to know, “Where can I invest my money that earns more than my savings account?”
To which I reply, “Nowhere. Let the cash sit in your savings or a money market.” It’s easy to underestimate the importance of the cash position. Of course, you don’t want to have gobs of cash hanging around for years on end without a plan, but a three-year run of saving for a down payment is not that. Most find this answer unsatisfactory, but I’m going to show you, in detail, the thinking behind the strategy.
I’m going to use Mary the moneymaker, to help me showcase my thinking. Mary has a goal of saving enough for a down payment for her apartment in two and half years. Her risk profile is not hyper conservative. But she’s not a balls-to-the-wall risk taker either. She is considered to be a moderately aggressive investor. (Which is pretty high on the spectrum. It’s just one notch below full throttle.)
So, she asks me where she can park her money and earn a return higher than her savings account.
I say, “Mary, the first step in searching for a higher return is looking at how much you can afford to lose. That is the very, very, first step.”
Most people, when they think of investing, they start thinking of how much they could make, but that’s the last step. The first step is asking how much could you afford to lose? (I cannot stress enough the value of this point.)
This is what Warren Buffet is saying in his quippy quote, “Rule number one: don’t lose money. Rule number two: see rule number one.”
Step #1 In investing: Calculate how much you can lose
So, let’s do that with Mary the moneymaker. How much of her money can she risk to lose and still meet her house funding goal?
The answer is none.
If she chooses an investment, and it loses value, she will not be able to meet her house goal in her stated time. Therefore, she can only invest in things that protect 100% of the principal.
So, what are your options if you can’t risk any of your capital? Savings accounts, CDs and money markets. And these choices are not created equal even though they carry similar returns.
Of the three choices above I’m going to weed out the worst one first. The CDs. I call them Certificates of Death. Not only do they give you a dismal rate of return, but you lose flexibility in the process. (You have to pay a penalty if they aren’t held to maturity.)
For example: If Mary found an apartment that was the deal of a lifetime, but her down payment was in a CD, she would have to pay a penalty to get out of the CD. Don’t do it.
Secondly, you have savings accounts. If you’re a really good saver and your money actually stays saved in your savings account, and you’re getting 1% return, keep your loot there. It’s FDIC insured up to $250,000, and you have unlimited flexibility (you can use the money whenever you want).
Lastly, if you have a hard time keeping your savings in your savings account, it’s better to open a money market. (My vote is at Vanguard.) Money market interest rates fluctuate with short-term interest rates. It’s not FDIC insured, but they are wickedly safe. (The only time you never got 100% of your money back is for a day or two in 2008 when it hit $.99. It’s the only time in history it has ever happened.)
It takes 2 to 3 days for money to be transferred back into your checking account, if need be, but there’s no penalty. Also, as interest rates rise your interest rates change automatically, so you don’t have to go shopping around for the new best interest rate.
The takeaway: If you have a short timeline and cannot lose any capital savings accounts, then money markets are the best place to park your money in the interim. Do not waste your time looking for a sexier answer. There is no such thing as a high, risk-free rate of return.