to your bank depends on the specific bank and the account that you use. With a CD, you commit to lend your money to the bank for a specific length of time — perhaps six months or even one or more years. In return, the bank probably pays you a higher rate of interest than if you put your money in a bank account offering you immediate access to the money. (You may demand termination of the CD early; however, you’ll usually be penalized.)
As Book 4 discusses in more detail, you can also invest your money in bonds, another type of lending investment. When you purchase a bond that’s been issued by the government or a company, you agree to lend your money for a predetermined period of time and receive a particular rate of interest. A bond may pay you 4 percent interest over the next ten years, for example.
An investor’s return from lending investments is typically limited to the original investment plus interest payments. If you lend your money to Netflix through one of its bonds that matures in, say, ten years, and Netflix triples in size over the next decade, you won’t share in its growth. Netflix’s stockholders and employees reap the rewards of the company’s success, but as a bondholder, you don’t; you simply get interest and the face value of the bond back at maturity.
THE DOUBLE WHAMMY OF INFLATION AND TAXES
Bank accounts and bonds that pay a decent return are reassuring to many investors. Earning a small amount of interest sure beats losing some or all of your money in a risky investment.
The problem is that money in a savings account, for example, that pays 1.5 percent isn’t actually yielding you 1.5 percent. It’s not that the bank is lying; it’s just that your investment bucket contains some not-so-obvious holes.
The first hole is taxes. When you earn interest, you must pay taxes on it (unless you invest the money in municipal bonds that are federal and state tax-free or in a retirement account, in which case you generally pay the taxes later when you withdraw the money). If you’re a moderate-income earner, you may end up losing about a third of your interest to taxes. Your 1.5 percent return is now down to 1 percent.
But the second hole in your investment bucket can be even bigger than taxes: inflation. Although a few products become cheaper over time (computers, for example), most goods and services increase in price. Inflation in the United States has been running about 2 percent per year over recent years (3 percent over the much longer term). Inflation depresses the purchasing power of your investments’ returns. If you subtract the 2 percent “cost” of inflation from the remaining 1 percent after payment of taxes, you’ve lost 1 percent on your investment.
To recap: For every dollar you invested in the bank a year ago, despite the fact that the bank paid you 1.5 pennies of interest, you’re left with only 99 cents in real purchasing power for every dollar you had a year ago. In other words, thanks to the inflation and tax holes in your investment bucket, you can buy less with your money now than you could have a year ago, even though you’ve invested your money for a year.
Considering Cash Equivalents
Cash equivalents are any investments that you can quickly convert to cash without cost to you. With most bank checking accounts, for example, you can conduct online transactions to pay bills or do the old-fashioned writing of a check or withdraw cash through an ATM machine or from retailers like a grocery store that enable you to get cash back when making a purchase.
Money market mutual funds (more commonly known as money market funds) are another type of cash equivalent. Investors, both large and small, invest hundreds of billions of dollars in money market mutual funds because the best money market funds historically have produced higher yields than bank savings accounts. (Some online banks offer higher yields, but you must be careful to understand ancillary service fees that can wipe away any yield advantage.) The yield advantage of a money market fund over a savings account almost always widens when interest rates increase because banks move to raise savings account rates about as fast as molasses on a cold winter day.
Why shouldn’t you take advantage of a higher yield? Many bank savers sacrifice this yield because they think that money market funds are risky — but they’re not. Money market mutual funds generally invest in safe things such as short-term bank certificates of deposit, U.S. government–issued Treasury bills, and commercial paper (short-term bonds) that the most creditworthy corporations issue.
Another reason people keep too much money in traditional bank accounts is that the local bank branch office or online bank makes the cash seem more accessible. Money market mutual funds, however, offer many quick ways to get your cash. Most money market mutual funds can be accessed online, just like most bank accounts. You can also write a check (most funds stipulate the check must be for at least $250), or you can call the fund and request that it mail or electronically transfer your money.
Choosing Where to Invest and Get Advice
Selecting the firm or firms through which to do your investing is a hugely important decision. So is the decision about from whom to get or pay for investing advice. The following sections address both of these topics.
Finding the best fund companies and brokers
Insurance companies, banks, investment brokerage firms, mutual funds — the list of companies that stand ready to help you invest your money is nearly endless. Most people stumble into a relationship with an investment firm. They may choose a company because their employer uses it for company retirement plans or they’ve read about or been referred to a particular company. Maybe one of your family members or friends recommended or got you started with a particular investment company.
When you invest in certain securities — such as stocks and bonds and exchange-traded funds (ETFs) — and when you want to hold mutual funds from different companies in a single account, you need brokerage services. Brokers execute your trades to buy or sell stocks, bonds, and other securities and enable you to centralize your holdings of mutual funds, ETFs, and other investments. Your broker can also assist you with other services that may interest you.
Deciding which investment company is best for you depends on your needs and wants. In addition to fees, consider how important having a local branch office is to you. If you want to invest in mutual funds, you’ll want to choose a firm that offers access to good funds, including money market funds in which you can deposit money awaiting investment or proceeds from a sale.
