Savings accounts are for suckers

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Probably one of the first things you learned about personal finance when you were a little kid was “Savings Accounts”.    

Yet, as an adult, savings accounts are a horrible place to put your money.  How can that be?  In fact, a savings account could easily be costing you thousands of dollars each year.  Yikes!!!

If you don’t have time to read the whole blog, here is your answer: a bond fund gives you 10x more interest with a minimal tradeoff in safety.  Okay, there you go.  If you interested in understanding my thinking more, here you go.

Crazy low interest rates

Savings accounts today give you an interest rate in the 0.1% range or so.  Maybe if you shop around you can get as high as 0.5%, but that’s probably about it.

Obviously, that’s extremely low.  We know that stocks historically have an 8-ish% return, but that of course exposes you to the risk that you might lose some of your savings when you need it (more on how big a risk this actually is in a second).  Suffice it to say, there are a lot of people who understandably don’t like the idea of having their savings account invested in volatile stocks.  Fair enough.

However, you could invest in bonds which are much less volatile than stocks and still get a much higher return that your savings account.  Going back to the mid 1980s (which is about as far back as I could easily get reliable data), you can see that bonds have an average return of about 6%.  Comparing that to what you could get from a savings account is no comparison.

Just to put some numbers to it, let’s say that you have a nice round number like $10,000 in savings account.  You get about 0.3% interest which comes to . . . wait for it . . . $30 per year.  Now compare that to a 6% bond; you’d get about $600 per year on average.  That’s a huge difference–$50 per month.  This decision just paid for your internet bill or your cell phone bill.  If you want to get extra nerdy (you never have to ask Stocky that twice), $50 each month for your 40 year investing career would come to about $100,000.

Risk of losing money

Okay.  We understand that savings accounts give horrible interest rates.  So why do people still use them?

My suspicion is two fold:

  1. They don’t appreciate that there is an alternative to savings accounts called bond funds.
  2. They have an “over-exaggerated” fear of losing some of their savings.

We just took care of #1, so we can’t claim ignorance anymore.  Now let’s look at #2.  This is a legitimate concern.

We know that stocks move around a bunch (March, anyone?), and historically lose value about one third of the time.  Bonds, however, are a much different story.  Bonds historically have gone down in value in a given 12-month period about 9% of the time.  And just for funsises, if you calculate the average amount bonds go down when they do go down, it’s about 1%.

How does that make you feel?  Everyone has different risk tolerances, but to me this is a slam dunk.  You can use a savings account and be guaranteed to make a very, very small amount of interest.  Or you could take a TINY step up the risk ladder.  There you have a 90% chance of doing better, and if you’re unlucky that 10% of the time you’re only losing 1% (about $100 if you have $10,000 in their savings account).

Bond returns (since 1987)1-year3-years5-years
Best18%13%12%
Median6%6%6%
Worst-4%1%1%
% of time losing money9%0%0%

And here’s the kicker.  That was just looking at one year.  We all know that crazy swings in stocks and bonds become tamer if we allow for more time.  At three years, the LOWEST return for bonds was 1% (not negative 1%, mind you, but you’re making 1%).  If you push your time horizon out to three years, which doesn’t seem all that unreasonable, at least based on historical performance for the past 35ish years, the worst you could do with bonds is the best you can do with a savings account.  The rest is upside.

Irrational fear of losing money

Going back to the questions before, with all this knowledge, why would people still pick a savings account.  I think this is a classic example of going with your heart instead of your head.  The math is pretty compelling, and making the right decision here becomes a major windfall.

But some people just have a visceral aversion to exposing themselves to the possibility of losing money.  I’ve racked my brain and I can’t really come up with serious scenarios where you have a really short time horizon for your savings (less than a year), and you have a really low tolerance for being short as little as 1%.

Maybe if you’re saving for a down-payment on a house you get close, but even then, that tends to be more than a year process and if you are unlucky and come up a bit short, you can just take an extra month or two.  Being silly, maybe if kidnappers took your spouse and gave you a year to come up with the ransom, you probably don’t want to risk being short.  But then you’re better off getting James Bond or Jason Bourne involved.

Seriously, it’s hard to imagine where the massive trade off in return from a savings account is worth the very small security of being 100% certain you won’t lose money.

Personally, I have not had a savings account since I was in college.  We have a checking account for our normal family expenses and then we use a bond fund for shorter-term stuff and then stock funds for long-term stuff.

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