Month: September 2020

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Last week I said that savings accounts were for suckers, and that instead you could use bonds to accomplish pretty much the same thing, but make a lot more in interest.  A couple readers asked how that worked in a little more detail.

“Hey thanks for the finance blog… What bond funds do you recommend (ETFs) and do you just hold them in a normal brokerage acct to be able to sell them?”  –JS

“How liquid are Bonds? Say I need a quick 5K for a new HVAC unit or some other unforeseen expense. Should I keep any money in a traditional savings account?”  –CW

If we like the concept of using bonds instead of a savings account, let’s dive into how we would actually do it.

1. Open a brokerage account with Vanguard (or Fidelity—we have money at both, but more at Vanguard and have been with Vanguard longer.  Both are excellent.  I’ll write this for Vanguard but in parenthesis I’ll put the information for Fidelity).  You want to make sure it’s a regular brokerage account and not an IRA or something like that.

As a “savings account” you’ll want be able to pull out money when you need it.  A brokerage account allows you to do that, but an IRA account would not.

2. Link your Vanguard account to your checking account.  This is very secure and I have never had an issue with it.

Online you’ll put in your checking account routing number and account number.  A few days later you’ll see two little deposits (think something like $0.21 and $0.09).  This allows Vanguard to ensure that it’s your account.  When you see those amounts, you’ll go back to Vanguard’s website and enter them.

Once you’ve confirmed those, then you’re Vanguard account will be linked to your checking account, so you can transfer money between them very easily.  Sadly, there’s no free lunch and Vanguard will take those two little deposits back.

3. Pick your bond fund.  Vanguard has a ton of options (as does Fidelity).  I want to keep it simple so I pick an index fund to minimize fees.  Also, I want to go as broad as possible to maximize diversification.  Basically, you can go one of two ways—either buy a bond ETF like BND or buy a bond mutual fund like VBTLX (for Fidelity it’s FXNAX).

ETFs are a lot more flexible and I think we’re entering a world where mutual funds will slowly go extinct in favor of ETFs.

4. Buy your BND shares.  Take what ever was in your savings account and buy shares of BND.  It’s a pretty easy process.  Depending on how much money we’re talking about, you might want to break it up into a couple purchases, although statistics say you should just dive in with a single purchase.

5. When you go to buy the shares, it will ask you how you want to fund them.  You’ll pick your bank account that you just linked and it will all work.

When you need to take money out of your savings account (like when CW’s heater goes bad), you just do the opposite—sell the shares and when it asks where you want the money you select your checking account.  Generally it takes about two or so business days to complete the transaction, so just make sure you plan a little ahead.

These ETFs are extremely liquid so you can sell them whenever the market is open.  In fact, you can also sell or buy them when the market is closed.  It will just fill the transaction at the next possible price, when the markets open next.

Easy peasy, lemon squeezy. 

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There was a time when a 7% drop in the stock market in three days would have been a big deal.  Now . . . meh.

The stock market peeked last Wednesday and then over the next three trading days promptly fell 7% (and then yesterday recovered about 2%).  You’d think that should be notable, but it really doesn’t seem like that.

Why a 7% drop isn’t a big deal

First, this has been a crazy year anyway, so a drop like this just seems like par for the course.  In fact, I think that speaks to how crazy things have been that we’re now numb to it. 

A 7% drop is actually a pretty big deal.  Since 1940 (I didn’t want to include the Great Depression where there were a lot of crazy drops), there have been 28 three-day drops that bad or worse.  Is that a lot or not too much?

28 times in 70 years means it averages once every three years or so.  That doesn’t seem too crazy.  As it happens, we had two such periods in 2020, once in February and again in March.  That’s probably not very surprising giving the total stock market meltdown we experienced then.  Before that you have to go back to 2015 and before that 2011.  That seems to line up with our average; this happens every few years.

But the difference is when this happened before in 2015 and 2011, it seems like we made a big deal of it.  Everyone, Stocky included, talked about it a lot, tried to figure out what caused it, and predicted when things would turn around.

This time it just seemed like another couple days.  Personally, I think after surviving the Corona stock market, we just expect this now.  Down 4% in one day, whatever?!?!?  My, oh, my, how far we’ve come (or how far we’ve fallen).

The other thing that made this drop not so bad is it seemed like we were just giving back the gains we made over the previous couple weeks. We lost a lot, but it felt like we just gave back the house money we won a few weeks earlier.

 The fall erased the gains we experienced since mid-August.  That doesn’t seem like all that big of a deal.  Easy come, easy go.

Crazy stock moves is just how 2020 rolls

Nothing about 2020 can really surprise us any more, but how does 2020 stack up to other years.  So far, we’ve had major stock market moves (up or down at least 1%) 46% of the time.  Nearly half the days have seen the stock market move dramatically—think up or down about 280 points for the Dow Jones.

That happens every once in a while, but what really makes 2020 crazy is that 16% of the days have had CRAZY major stock moves (up or down at least 3%–about 800 points for the Dow Jones).  That’s the one that seems remarkable.  That means almost once a week, we’re seeing something crazy happen.  Wow that’s exhausting.

Historically, 2008 had that many crazy big days (the Great Recession).  Before that you have to go all the way back to 1933 and the Great Depression.  That puts things in perspective.  What we’re going through is crazy, but it definitely feels that we’ve just accepted a heightened level of crazy as our new normal.  Sigh.

As always, I remain fully invested and optimistic about the market.  I guess I just need to keep some Pepto close at hand. 

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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-year	3-years	5-years
Best	18%	13%	12%
Median	6%	6%	6%
Worst	-4%	1%	1%
% of time losing money	9%	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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“Nothing ventured, nothing gained”—Benjamin Franklin

That Benjamin Franklin guy was pretty smart.  This is not the first time one of his quotes have landed on this blog.  When you enter the world of investing, you need to figure out how you balance the two fundamental, opposing forces of investing: risk and reward.  At its simplest, investments compensate investors who take on greater risk with higher returns.

Think of the least risky investment you could make—a savings account.  You could invest your money and know that your investment won’t lose money.  You could take out the money in a week, a month, or a year; and you would get your original money plus a very small amount of interest.  In the US, the risk of you losing money on this investment is 0%.  Unfortunately, because there’s no risk, the “reward”, the interest you make, is extremely low: less than 1% currently.

Let’s take a small step up the risk scale—short term government bonds.  The chances of you losing money investing in a 1-5 year treasury bond (let’s assume you invest in a short-term bond mutual fund like VSGBX), are extremely low, but it isn’t 0%.  There is a chance, albeit small, that changes in the market (interest rates) could decrease the value of your investment.  You’re taking on a little bit of risk (since 1988 there has never been a year where VSGBX has lost money), and to compensate for that risk these investments historically tend to return about 1-2%.  So you’re being paid a larger return than your savings account because you’re taking on more risk.

Take another step up the risk scale and you get to long-term government bonds and corporate debt (using a mutual fund like VBMFX).  These are riskier because there is some chance that you won’t get paid back; this is true for corporate, foreign, or municipal debt.  These are also riskier because like their less-risky cousins, the short-term bonds we just mentioned, long-term bonds can change in value due to changes in things like interest rates.  The difference with long-term bonds is that the effects are magnified; so if interest rates go up, that would cause the value of your short-term bonds to go down a little, but the prices on your long-term bonds would go down much more.  As you would expect, since long-term bonds are a little riskier (since 1988 VBMFX has lost money in 2 years), they tend to return a little more, historically in the 3-5% range.

Now, take a big leap up the risk curve and you get to stocks.  Stocks are extremely volatile, especially over the short-term.  Since 1930, there have been 24 years (about one-third of the time) where US stocks have decreased in value.  It’s definitely a rollercoaster ride.  Yet, by bearing the risk that in any given year your investment might go down in value, sometimes down a lot like in 2008 when stocks went down 37%, you get a significantly higher return.  Since 1930, stocks have returned on average about 8%.

As you can clearly see in the chart, when you invest in assets with higher average returns (like stocks) you have a lot more volatility in those returns from one year to the next.  When you invest in assets with lower average returns (like bonds, especially short terms bonds or even cash), you enjoy much more stability in the value of your investments.

What’s your appetite for risk?

As an investor you need to determine what your appetite for risk is.  How will you balance the yin of high returns with the yang of higher risk?  At the end of the day, you need to have an investing strategy that allows you to sleep at night.  There’s no amount of money that’s worth freaking out every time the market takes a down turn, and it is certain that the market will take down turns.  Sometimes it will be a free fall like in 2008 when stocks cratered 37% or it might be a long-term grind like from 1973 to 1978 where stocks fell 23% over the course of 5 years.

That said, a long time horizon is your best friend when dealing with a volatile stock market.  While any given year might be crazy, over time there tends to be more good years than bad.  Take 2008: in 2008 stocks fell by 37%, and if you needed your money at the end of that year you were hurting.  On the other hand, if you had a longer-term investing horizon and were able to stay in the market, all your money would be made back by 2012.  In fact, while about 33% of the years have been down years for stocks since 1930, over that same period of there was only one decade, the 1930s, when stocks were down.

So how do you invest?  Well, you need to figure out your risk tolerance.  Here’s a good way to do that.  Imagine yourself as an investor at the end of 2008.  You’re in the depths of the financial crisis, stocks are down 37%, and pundits are saying we may be on the brink of financial collapse.  What do you do?

Some people like Warren Buffett and Stocky Fox (for important statements I revert to the third person) looked at that as an opportunity to continue to invest in stocks, just now we were buying them at a substantial discount compared to 2007’s prices.  In the end our faith was rewarded and we made a killing.  However, there were some times when the news just kept getting bad and Pepto-Bismol came in extremely handy.

Others felt burned by the 2008 investing bloodbath and pulled their money out of the stock market to put it in safer investments like bonds or cash.  They did so knowing their actions limited their potential for higher returns, but many were willing to accept that if it meant not having to risk their money continuing to disappear into the black hole of the financial crisis.

There’s no right or wrong answer.  You just need to figure out where you’re comfortable and invest accordingly.  If you’re willing to weather the storms then you should probably invest more in stocks.  If you’re more risk averse, then you should probably invest a larger portion of your portfolio in bonds.

Just remember, there’s no such thing as a free lunch.  With higher returns come higher risk.  If you want safer investments, you have to be willing to give up higher returns.