In today’s low interest rate environment, many savers ask themselves if it still makes sense to save money. If the money doesn’t earn any return, why would you want to save money after all?
Saving for emergencies
One reason to save money without any regard is for emergencies. Here it doesn’t matter how much money you earn, what matters is that the money is safe and readily accessible. Experts recommend having at least six months of expenses in an emergency fund. This money should be stored in a safe place like a savings account (preferably high-yield savings account to earn some money), money market account, or money market fund.
Some experts also recommend certificates of deposit (CDs) where you agree to tie up your money for a certain amount of time and in return you receive a monthly interest payment. However, unless the CD is a no-penalty CD that allows you to get back your money at any time (there is usually a 7-day waiting period) without paying a penalty, you will lose money if you need to access the money before the CD matures.
Paying off high-interest debt
Once you have your emergency fund in place, what should you do with your money that is left at the end of the month (or paycheck period)? Before considering any other saving and investment options, you should check if you have any high-interest debt. In most cases this would be credit card debt. If you carry a credit card balance from month to month, prioritize paying it off as quickly as possible. No other investment (in particular one that is 100% risk-free) will give you as much of a return as paying off credit card debt. Even if you got a good deal on a credit card with low or no interest rate, still try paying it off so that it doesn’t become high-interest debt once the introductory period is over.
Inflation risk
What should you do with your money if you don’t have any high-interest debt? One option is to keep adding to your savings account. This option might be safe in the short term, but in the long run you will likely lose a lot of money. That’s because savings accounts don’t provide much return compared to other investment options. For most time periods (especially in today’s low interest rate environment), the yield that you get on savings accounts doesn’t even match the inflation rate. This means, you effectively lose money over time. This is known as inflation risk.
Investing in real estate
Many financial experts recommend investing in real assets like real estate and stocks that at least keep up with inflation. Some investors firmly believe that real estate investing is one of the most lucrative investments that exist. Although it is true that real estate investing can be very rewarding, it also comes with a few downsides (in this section we will be focusing on directly buying and managing real estate, not investing in Real Estate Investment Trusts (REITs), which eliminates some of the downsides).
The main downside is that for the average real estate investor with limited funds, it’s very difficult to properly diversify the investment across multiple properties and across multiple regions. That’s because the amount of money that needs to be invested in a single property is relatively high. As a result, the average investor will only be able to invest in a handful of properties that are most likely located in the same region. If the investor runs into issues with one property or if a location turns into a less desirable location (e.g., due to a factory shutdown), it will have a substantial negative effect on the overall return on investment.
Another downside is that real estate investments are considered illiquid. It takes time to sell a property in the event that you need to raise cash; and if you need to sell quickly, you often need to accept a lower selling price for your property.
And finally there are costs involved in owning a property. You need to pay property taxes and insurance, spend time and money on maintaining the property, and you have to deal with bad tenants. If you don’t have much experience with running a property, you will most likely not be able to cost-effectively run the property, which will reduce the return on your investment.
Many investors consider their primary residency as an investment - but here the same issues apply: you only have a single property (i.e., less diversification), there are costs involved in owning the property, and on top of that you don’t have any cash flow because of no paying tenants and so you rely solely on the price appreciation of your property (they only appreciate at the rate of inflation on average).
One upside of real estate investing is that property values are less volatile than stock prices in the short term (which is less important for long-term investors as we will see later). But considering all the negative aspects of real estate investment, it can be considered as relatively high-risk for the average investor (which doesn’t necessarily translate to higher returns due to the limited diversification).
Investing in bonds
If real estate investing is considered high-risk for the average investor, then what investment options exist that are less risky? One of the lowest-risk (at least in the short term) investment options are bonds. When you buy bonds, you essentially loan money to an entity (e.g., governments and corporations) for a certain period of time and in return they promise to pay you interest.
When you loan money to a government (assuming it’s a credit-worthy government like the U.S. or German government), it’s pretty much guaranteed that you get your money back. That’s because governments own the money printing machines and can effectively “print their way out of debt” (assuming that the issued bonds are in the currency of that government). On the other hand, if you buy bonds that are issued by a corporation and the corporation becomes bankrupt, there is a good chance that you will lose a portion or even all of your money. However, it’s still safer to buy corporate bonds than stocks because creditors (you in this case) get paid first from the liquidated assets of the bankrupt corporation. So, why would you then buy corporate bonds in the first place if they are more risky? In general, higher risk often means higher reward. In the case of bonds, this usually translates into higher interest rates for corporate bonds compared to government bonds.
Are bonds then considered to be a good investment? They can be. For risk-averse investors, bonds can be a good investment. For instance, many retirees who live on their investment income rely heavily on the steady income stream of bonds. But are they good for everyone? Not necessarily. Bonds have a few downsides as well.
First, safe bonds with high credit ratings (i.e., how likely is it that the bond issuer defaults on its debt) and with a short bond duration (the shorter the duration, the less the bond price will fluctuate over time due to interest rate changes, also known as interest rate risk) don’t offer much return. For such safe short-term bonds, the yield is similar to savings accounts and thus will often not even match the inflation rate. On the other hand, less safe long-term bonds will offer higher returns, but the increased risk involved make them less attractive for risk-averse investors.
Because the risks associated with bonds are of a different kind, it may still make sense for some investors to complement other investments (like stocks) with bonds to improve the overall risk-adjusted return of a portfolio. However, for investors with a long investment horizon (greater than 10 years), bonds are not very attractive in the current low interest rate environment due to the low yield and the risk of falling bond prices once the interest rates start rising again.
Investing in stocks
What is the best investment option for long-term investors then? For most long-term investors, stocks were and will always be the best investment option.
Although the stock market can fluctuate heavily over the short term, and sometimes it even crashes, over the long run stock market returns were always positive and considerably higher than the ones on bonds and any other supposedly safer investments. This was the case in the past and it will likely be the case in the future (there wasn’t a single instance in the history of the U.S. stock market where it had a negative return within a 20-year timeframe).
As a result, it doesn’t even matter if you buy stocks when the stock market is at a record high - over the long term the return will still be positive. This also means that it’s important that you stay the course and don’t panic and sell your stocks when the stock market is down. This would mean that you sell your stocks when their prices are low and thus potentially lock in losses. It would also mean that you miss out on the gains when the stock market rises to its new heights again.
There is also a general consensus among investors that it’s really hard to know when it’s a good time to enter the market, and because of the power of compounding (i.e., your investment grows exponentially), it’s important to not wait before starting investing. As an old saying goes: “Time in the market is more important than timing the market.”
Investing versus speculating
Some final thoughts on buying cryptocurrencies like Bitcoin for investment purposes. The most important requirement for making any investment decisions is being able to value an investment so that you know if the asking price is reasonable. Using existing valuation techniques, it’s very difficult to value cryptocurrencies, especially because they don’t provide any cash flow. You basically rely on the belief that there is always someone else out there who is willing to pay more than you did for the cryptocurrencies you hold. This is also known as the greater fool theory. That’s why many financial experts consider buying cryptocurrencies speculating rather than investing.