Reaching For The Best Interest Rates On Savings Can Get You In Trouble

Everybody wants to get the best interest rates on their savings, but I think that’s the wrong question to ask. The right question, in my opinion, is “what are the best interest rates for savings for my specific goals?” For example, an emergency fund should be as liquid as possible and so earning the highest rate possible on those savings should be a secondary consideration. To be sure, there’s nothing wrong with using the highest interest rate savings account you can find that meets your other criteria, but it should not be the primary deciding factor. Otherwise, you’ll end up taking on too much risk for a small incremental yield.

Don’t Reach For Yield

The act of downgrading the overall quality of your savings (or portfolio) in order to get a higher yield on your savings is called “reaching for yield,” and it’s often a bad thing. Why? Because in any remotely efficient capital market such as the ones we have in this country, you can’t have more return without risk. When you reach for yield, you increase the probability that your money won’t be there when you need it due to inopportune market losses. While that kind of risk is acceptable for long-term goals, it is absolutely not for short-term goals, much less your emergency fund. Does that mean you should never take on more risk? Of course not. But there’s a time and a place for that. Hint: it’s not with your short-term savings

In general, you should divide your savings into three pots:

Ultra Short-Term Emergency Savings

This is your emergency fund. If your car needed $2000 in repairs tomorrow, this is how you would pay for it. Consequently, it should be money you can get to almost instantly, or at least soon enough so that you can afford to pay off your credit card at the end of the month should you use credit to cover the unexpected expense. For emergency funds, most experts recommend a regular old savings account at your bank or a high-yield savings account online. Personally, I prefer online banking because a.) it’s more convenient and b.) the rates are usually much higher. For example, I use ING Direct for my emergency fund (click here to find out why I chose ING Direct over other higher-yielding online savings accounts). In my opinion, bond funds (even short-term bond funds) are totally inappropriate for emergency savings. There is a school of thought that states this is dead money and entails too high an opportunity cost, but I strongly disagree: better safe than sorry. Unless you have a high net worth and can afford to sell assets at a loss, the negative consequences of risking your emergency fund are too high to bear  for most investors.

You can use a site like Bankrate to find the best bank interest rates on different types of savings accounts.

Intermediate-Term Savings

Do you plan on buying a new car in 5 or 6 years? Saving up for a down-payment on a home in 3 years? Since you more or less know when you’ll need the money and how much you’ll need, you can afford to reach for yield a bit here. Let’s define “intermediate-term” in this case to be any goal over 1 year and less than 8 years away. For these goals, you’re generally best off investing in either high yield FDIC-insured CD’s or bond mutual funds with an average effective duration less than your time horizon. For instance, if you are saving for an expense 6 years down the road you should feel free to invest in a bond fund with an effective duration of less than 6 years, which includes most short- and intermediate-term bond funds. Alternately, you could buy an individual treasury bond directly from the U.S. Treasury at TreasuryDirect.gov and bypass the management expense. You should still stick with high-quality issues here, though, meaning no junk bonds and no stocks (unless you have so much money that it doesn’t matter if you miss your target, in which case all bets are off).

Long-Term Savings

This is your retirement portfolio and other long-term savings for goals 10+ years out. Your long-term savings should probably be equity-oriented within your risk tolerances and anchored by an allocation of high-quality short- or intermediate-term bonds. If you’re going to take risks in an effort to strike it risk, this is the only appropriate portion of your portfolio in which to do it. Go ahead and over-weight small-cap stocks, or emerging market stocks, and maybe even own an individual stock or two and some junk bonds. Don’t go crazy, but you’ve got plenty of time to recover from a few setbacks.