Money market funds and savings account returns

Be sure to keep your extra cash that awaits investment (or an emergency) in a safe place, preferably one that doesn’t get hammered by the sea of changes in the financial markets. By default and for convenience, many people keep their extra cash in a bank savings account, which tends to pay relatively low rates of interest. Banks accounts come with Federal Deposit Insurance Corporation (FDIC) backing, which costs the bank some money.

Another place to keep your liquid savings is a money market mutual fund. These funds are the safest types of mutual funds around and, for all intents and purposes, comparable to a bank savings account’s safety. Technically, money market mutual funds don’t carry FDIC insurance. To date, however, only one money market fund has lost money for retail shareholders (and in that case, it amounted to less then 1 percent).

The best money market funds generally pay higher yields than most bank savings accounts (although this has been less true in recent years, with low overall interest rates). When shopping for a money fund, be sure to pay close attention to the fund’s expense ratio, because lower expenses generally translate into higher yields. If you’re in a higher tax bracket, you should also consider tax-free money market funds. (See Chapter 7 for all the details on money market funds.)

If you don’t need immediate access to your money, consider using Treasury bills (T-bills) or bank certificates of deposit (CDs), which are usually issued by banks for terms such as 3, 6, or 12 months. The drawback to T-bills and bank certificates of deposit is that you generally incur a transaction fee (with T-bills) or a penalty (with CDs) if you withdraw your investment before the T-bill matures or the CD’s term expires. If you can let your money sit for the full term, you can generally earn more in CDs and T-bills than in a bank savings account. Rates vary by bank, however, so be sure to shop around.

Bond returns

When you purchase a bond, you should earn a higher yield than you can with a money market or savings account. You’re taking more risk because some bond issuers (such as corporations) aren’t always able to fully pay back all that they borrow.

By investing in a bond (at least when it’s originally issued), you’re effectively lending your money to the issuer of that bond (borrower), which is generally the federal government or a corporation, for a specific period of time. Companies can and do go bankrupt, in which case you may lose some or all of your investment. Government debt can go into default as well. You should get paid in the form of a higher yield for taking on more risk when you buy bonds that have a lower credit rating. (See Chapter 9 for more information on bonds, including how to invest in a diversified portfolio of relatively safe bonds.)

Jeremy Siegel, who is a professor of finance at the Wharton School at the University of Pennsylvania, has tracked the performance of bonds (and stocks) for more than two centuries! His research has found that bond investors generally earn about 4 to 5 percent per year on average.

Returns, of course, fluctuate from year to year and are influenced by inflation (increases in the cost of living). Generally speaking, increases in the rate of inflation, especially when those increases weren’t expected, erode bond returns.

Consider a government bond that was issued at an interest rate of 4 percent when inflation was running at just 2 percent. Thus, an investor in that bond was able to enjoy a 2 percent return after inflation, or what’s known as the real return — real meaning after inflation is subtracted. Now, if inflation jumps to, say, 6 percent per year, why would folks want to buy your crummy 4 percent bond? They wouldn’t, unless the price drops enough to raise the effective yield higher.

Longer-term bonds generally yield more than shorter-term bonds, because they’re considered to be riskier due to the longer period until they pay back their principal. What are the risks of holding a bond for more years? There’s more time for the credit quality of the bond to deteriorate (and for the bond to default), and there’s also more time for inflation to come back and erode the purchasing power of the bond.

Stock returns

The long-term returns from stocks that investors have enjoyed, and continue to enjoy, have been remarkably constant from one generation to the next. Since 1802, the U.S. stock market has returned an annual average of about 6 to 7 percent per year above the rate of inflation. That’s a remarkable track record, but don’t forget that it’s an annual average return.

Stocks have significant downdrafts and can easily drop 10, 20, or 30 or more percent in relatively short periods of time. Stocks can also rise dramatically in value over short periods. The keys to making money in stocks are to be diversified, to invest consistently, and to own stocks over the long run.

Stocks exist worldwide, of course, not just in the United States. When investing in stocks, go global for diversification purposes. International (non-U.S.) stocks don’t always move in tandem with U.S. stocks. As a result, overseas stocks help diversify your portfolio. In addition to enabling U.S. investors to diversify, investing overseas has proven to be profitable over the years and decades.

Now, some folks make stock investing riskier than need be by doing some foolish things:

• Chasing after specific stocks or sectors that have recently been hot: Yes, what a rich genius you’d have been if you’d invested in Apple stock (or Google, Amazon, or Facebook) when it went public. With the benefit of hindsight, it’s easy to spot the “best” stock investments (companies or sectors) over specific periods. It’s quite another thing to put your money on the line now and to hope and expect that you have the ability to pick the best-performing stocks of the future.
• Excessive trading and market timing: Another type of wishful thinking occurs when folks would like to believe that they can jump into and out of the market at the right times to participate in moves higher and to sidestep downturns.

Chapter 8 goes into detail on stocks, explaining how to invest in them successfully and not lose your shirt.

Real estate returns

Just before, during, and for some time after the financial crisis of 2008 and associated severe recession, most types of real estate in most parts of the country declined in value. Thus, you may think that real estate isn’t a good investment, but you’d be wrong.

Real estate is a solid long-term investment. Real estate, as an investment, has produced returns comparable to those of investing in the stock market. Both stocks and real estate have down periods but have historically produced attractive long-term returns. Overall, real estate prices in most parts of the United States now have bounced back to record high levels.

Real estate does well in the long run because of growth in the economy, in jobs, and in population. Real estate prices in and near major metropolises and suburbs generally appreciate the most because people and businesses tend to cluster in those areas.

I’d like to make an important caution here about viewing a home in which you live solely as an investment. As I discuss in Chapter 12, your primary reason to buy and own a home should not be high expected investment returns, because you won’t be earning rental income if you live in your own home. That’s why you should thoroughly understand the effect that owning a home will have on your monthly spending and budget. (Investment real estate examples include a small apartment building and retail space.)

Small-business returns

When we think of the “American dream,” one image that comes to the minds of many folks is owning their own business and possibly making it big by doing so.

You have numerous choices for tapping into the rewards of the small-business world. If you have the drive and determination, you can start your own small business. Or perhaps you have what it takes to buy an existing small business. If you obtain the necessary capital and skills to assess opportunities and risk, you can invest in someone else’s small business. None of these avenues is easy. In fact, all these routes require drive, determination, and some skills and money (more on this in Chapter 14).

By starting a small business and retaining a major ownership stake, you can earn very high effective returns. Unlike with the stock market, for which plenty of historic rate-of-return data exists, no specific data exists on the returns that small-time investors have had from investing in small private companies. (We do know that successful venture capital firms, which invest in small businesses with large potential, earn generous returns for the general partners.)

While the financial rewards can be attractive, there are other rewards from investing in small businesses. In my small-business ventures, for example, I’ve enjoyed designing and running businesses that provide useful and valued services. I also enjoy having flexible work hours and not feeling like I’m punching a time clock to satisfy a boss.

The value of getting a few extra percent

As I discuss in Chapter 1, investing in the stock market (and real estate) can be risky, which logically raises the question of whether investing in stocks and real estate is worth the anxiety and potential losses. Why bother for a few extra percent per year?

Here’s a good answer to that sensible question: Over many years, a few extra percent per year will increase your nest egg dramatically. The more years you have to invest, the greater the difference a few percent makes in your returns (see Table 3-1).

These numbers are simply amazing! Start first with the 25 year column in Table 3-1. For every $1,000 invested over 25 years, you’ll have $1,282 at a 1 percent annual return. At a 9 percent return, you’ll have $8,623, or nearly seven times as much! Now look at what happens over 40 years. At a 9 percent investment return, you’ll have more than 21 times as much money versus what you’d have with a 1 percent annual investment return.

Here’s a practical example to show you what a major difference earning a few extra percent can make in accomplishing your financial goals. Consider a 30-year-old investor who’s saving toward financial independence/retirement on his $40,000 annual salary. Suppose that his goal is to retire by age 67 with about $30,000 per year to live on (in today’s dollars), which would be about 75 percent of his working salary.

If he begins saving at age 30, he needs to save about $460 per month if you assume that he earns about 5 percent per year average return on his investments. That’s a big chunk to save each year (about $5,500) — amounting to about 14 percent of his gross (pretax) salary.

But what if this investor can earn just a few percent more per year on average from his investments — 8 percent instead of just 5 percent? In that case, he could accomplish the same goal by saving just half as much: $230 per month (or $2,800 per year)!

Considering your goals

How much do you need or want to earn? You have to balance your goals with how you feel about risk. Some people can’t handle higher-risk investments. Although investing in stocks, real estate, or small business can produce high long-term returns, investing in these vehicles comes with greater risk, especially over the short term.

Others are at a time in their lives when they can’t afford to take great risk. If you’re still in school, if you’ve lost your job, or if you’re starting a family, your portfolio and nerves may not be able to wait a decade for your riskier investments to recover after a major stumble.

If you work for a living, odds are that you need and want to make your investments grow at a healthy clip. Should your investments grow slowly, you may fall short of your goals of owning a home or retiring or changing careers.

All this is to say that you should take the time to contemplate, enumerate, and prioritize your personal and financial goals. If you haven’t already sorted them out, see Chapter 2 to get started.