I’ve had a lot of conversations lately about squeezing more growth out of low-risk investments. Here’s two examples:
- Some bank certificates of deposit (Navy Federal, Andrews Federal) are offering annual percentage yields (APY) of 3%, the highest rate in years. A friend considering CDs for his emergency fund asked, “Why would I put my emergency fund in CDs when I can invest in dividend stocks and get better returns?”
- A coworker needs to replace a safe investment in our old 401k with a similarly safe investment in our new 401k. She’s concerned that the new investment had a lower annual return (2.7% vs 2.5%). However, it also had substantially lower fees, meaning its net return was substantially higher (1.9% vs. 2.4%).
The first immutable law of investing is that higher returns are rewards for higher risk. Stocks have historically higher returns (7-10% annual average growth) than bonds (5-6% annual average growth) because there’s less risk in lending to a company than owning it. Savings accounts have higher rewards than checking accounts because you are limited in how frequently you can withdraw from your savings account. Have there been periods when bonds outperform stocks? Of course, see the 2008 financial crisis! But over a long time, riskier asset classes outperform safer assets.
So for my dividend-stock inclined friend, yes, we would expect dividend paying stocks to yield higher returns than CDs over time because they are far riskier. However, there’s no guarantee that stocks maintain their value and you can lose your principal. A CD returning 3% will never lose principal and never yield less than 3%. If you are willing to lose your emergency fund, invest in riskier assets. If not, then take the guaranteed 3% and be happy.
The second immutable law of investing is that death, taxes, and fees are certain, returns are not. A return of 2.5% with no fees and a return of 5% with 2.5% fees have the same net result, 2.5% growth. But in a bad year, a return of 0% with no fees is unpleasant but a return of 0% with 2.5% fees is a net loss.
When comparing investments, always compare expected future returns vs. inflation and the cost of investment (fees, taxes, commissions). Since I cannot predict the future, I give far more weight to keeping predictable costs low than unpredictable returns high. Look at the table below, which of these bond funds is the best investment for protecting principal assuming an inflation rate of 2%?
|Investment||Expected Annual Return||Fees||Real Return||Inflation||Return after Inflation|
|Actively Managed Bond Fund||3.00%||0.90%||2.10%||2.00%||0.10%|
|Bond Index Fund||2.50%||0.10%||2.40%||2.00%||0.40%|
If your primary goal is to protect your principal, pick the 3-year CD. If you’re willing to take on a little more risk, pick the Bond Index Fund. Even though it underperforms the actively managed fun by 0.5%, it’s return after fees is greater. However, only the CD is guaranteed to return 2% per year.
Before investing in fixed income investments, keep these questions in mind. Notice how “what growth do I need?” is not considered. If you’re not willing to take a short-term loss on your investment, then expected growth is a secondary consideration.
- Can I lose my investment? If you can’t live with a 10% drop in value, you need a safe investment. If you can live with an immediate 50% drop in the value of your investment, then you should invest in risker assets such as stocks or real estate.
- When will I need to make my first withdrawal (liquidity)? If you might need the money tomorrow, deposit into a checking or savings account. If you can wait one year, invest in a 1-year CD. If you can wait longer, consider bonds, bond funds, or long-term CDs.
- How can I protect my principal (minimize risk)? For government bonds, CDs, and savings accounts, you can expect to at least withdraw whatever you put in.
- How can I defend against inflation? If annual inflation is 2% and your annual return is 1.8%, you’re losing 0.2% in purchasing power per year. You’re not losing money per se, but what you have is worth less.If you’re investing for the short-term a 1% savings account is still better than 0%. If you’re investing for the long-term, you need to be reasonably certain your investment will beat inflation.
- Can I add more growth above inflation? If annual inflation is 2% and your investment returns 2.5%, your net gain is 0.5%. It’s not too difficult to find longer-term investments (government bonds, high-yield CDs, bond index funds, etc. ) that beat inflation, but checking and savings accounts tend to have returns below inflation.
- Can I minimize taxes on growth? Since growth is guaranteed, so are taxes. If annual inflation is 2% and your investment returns 2.5% and your effective tax rate is 20%, your net gain is 0.4%. If you’re willing to hold your fixed income investments in your retirement accounts, you can avoid (Roth) or delay (401k, traditional IRA) paying taxes altogether.
How do you approach your fixed income investments? Where do you keep your emergency funds? Have you taken on riskier investments in a low-interest rate environment?