Investments vs. Savings- A Resident Guide- Part 1
The distinction between investing and savings is not trivial. It can lead to the loss of thousands of dollars if the two ideas are misused or confused. Since most residents do not have business backgrounds, I’m pretty sure there is a high percentage of radiology residents that do not understand the difference between investments and savings. So, I am going to simply define each, show why it is so important to understand the distinction, and then go into more detail about what constitutes savings. Due to time constraints, I will leave a full investigation of types of investments and how to invest in another blog. (Let’s make it part 2!!!)
Savings vs. Investment Definition
First off, the definitions. Savings are short-term instruments for keeping/holding onto money, usually for less than 5 years. Investments are long-term instruments for creating wealth.
Why is this the distinction so important? If you are putting investment money into savings, you are losing out on the opportunity cost of making high interest/capital appreciation on your money. Likewise, if you are putting savings money into investments, you are substantially increasing your risk on money that you need, or risking the need for capital preservation.
What can happen if you treat an investment as savings?
Let’s start with a thought experiment: putting investment money into savings. Imagine you have 1,000 dollars that you can afford to put away for a long period of time. Logically, what is the safest way to utilize this money? Many would say put it in an FDIC insured bank account, possibly a certificate of deposit. Wrong, wrong, wrong!!! In fact, the risks to this money become substantial.
What can you get on a 5 year CD? Maybe 2 percent, if lucky. Now, what is the current inflation rate? It is about 1.86%. (There is handy calculator called the CPI calculator that you can use to calculate the yearly inflation rate). So, you decide to put the 1000 dollars into a 5 year CD. At the end of 5 years, you collect the interest which is 1000 * (1.02^5-1) or about 104 dollars. But wait. The government has to take its fair share of the interest with taxes. Taxes on interest are pretty much the same as your regular income taxes. So, let’s say you are in the 25% tax bracket and you have a 3% state tax on interest, you are now left with 104*(1-(0.25+0.03) or around 75 dollars. So, you have 1000+75 or 1075 dollars after taxes and interest. However, what is 1075 really worth 5 years later? Here, we need to take the prevailing cpi number (for simplicity sake we will assume it is 1.86% each year, the current cpi rate). So we take the 1075 dollars and divide that by the following number- 1.0186^5, or 1.097, the total effect of inflation over 5 years. So how much is the 1075 dollars in 5 years be worth in present dollars- that would 1075/1.097 or 980 dollars. Think about it. The 1000 dollars that you put into the 5-year cd is really worth only 980 dollars when you take it out. That’s a really raw deal. Your money will be guaranteed to be eaten up by taxes and inflation in this low-interest environment over a long period of time. Don’t put your investment money into savings!
What can happen if you treat savings as an investment?
Alright, let’s take the opposite situation. You have a 12-year-old car that is on it’s last 10-20 thousand miles. You decide to take that 1000 dollars and put it into an S & P index fund. And, you intend to save for a car over the next three years when you think you will need one. It happens to be the year 2006. What happened to the S & P index fund between Jan 1, 2006 and Jan 1, 2009? It fell by 35%. And, you need that money to afford to buy a car in 2009. So, now you only have 1000*(1 -0.35) or 650 dollars in 2009. You may now not be able to afford to buy the car you wanted. Even worse, you may have to take that 650 dollars and use it to buy your car. Think about it. Subsequently, in the period of time afterward from 2009-2016, the stock market went up about 158 percent. That same original 1000 dollars you would have put into the index fund would have been worth over 68% more in 2016 or (1.68*1000) 1680 dollars if you kept it invested. Or that 650 dollars that you used in 2009 would have been worth 1680 dollars in 2016. Hmmm… 650 dollars vs. 1680 dollars only 7 years later, a striking difference.
The problem is you need to use your savings when you need to use your savings. You have little control over timing. Often times, you will wind up selling your investment at a low point, meaning that you will lose the potential capital appreciation of your initial investment. Any money that you need over the short term should not be placed in an instrument with significant risk. Never put your short-term savings into an investment!
Types of Savings
So now you understand why it is important not to take too many risks with your money for short-term needs. But, there are many options. For the uninitiated, this can seem daunting. I think of it as a multilayered approach. Let’s put the type of savings into two different types of buckets: money you may need for something immediately (100 percent liquid savings) and money you don’t need immediately but you will need in the short term future (up to 5 years later).
Liquid Savings Accounts
Which savings instruments are 100 percent liquid? Checking accounts, money market accounts, FDIC insured savings accounts, and money market funds,
I will begin with checking accounts, probably the most familiar. You can establish a checking account at almost any bank or credit union, online or in person. And, you probably have one already. It usually issues almost no interest but allows instant access anytime. I personally have a checking account with a local branch, but an online checking account is likely ok for most people.
Money market funds are safe heavily diversified accounts that invest in large numbers of short-term notes that usually return a nominal amount of interest. They are common at brokerage houses. Some allow you to write checks on the account. They are a good place to park cash temporarily, often as an instrument to buy investments at some point. But, it is safe enough to be considered 100 percent liquid and a savings instrument.
Money market accounts are available at banks and usually also allow instant access to your money, but for a limited number of times per month. You can typically write checks on the account. The advantage of this account: they usually provide a higher interest rate than a checking account and it is also FDIC insured. I would tend to put money in this account for less frequent and larger expenses. Also, if someone steals your checking account information, it provides an additional level of security. Not all of your money will be at the most readily accessible checking account.
And, there are FDIC insured savings accounts. They are very similar to money market accounts but usually don’t allow direct checks against them. You can move money instantaneously in and out of them electronically. Similar to money market accounts, they provide a higher level of interest. I personally recommend looking into online savings accounts because they tend to issue a higher interest rate because these online banks don’t have the fixed costs of local branches. This sort of account can be used to save for short-term larger purchases.
Less Liquid Savings Options
Let’s say you don’t need instant access to your money, but you do need it sometime in the near future. These options provide a slightly higher interest rate with the main intention of capital preservation and not capital appreciation. Remember, these savings instruments should not be seen as means to make tons of money, but rather a means to be able to pay for important/necessary expenses. Many residents have not had much experience with these options. Nonetheless, they are really important to understand. What are some of these options? The main ones are bank CDs, brokerage CDs, short-term Treasuries, “investment grade” short-term municipal bonds, and “investment grade” short-term corporate bonds.
So let’s talk about bank CDs first. The type of bank CDs I am talking about are FDIC insured bank CDs only. These CDs guarantee a fixed interest yearly interest rate for the duration of the time of the CD. You can use the principal and interest without penalty when the bank CD comes due. If you decide to cash in the CD prior to the due date, there is an often an interest penalty that can vary with the bank offering the CD. Bank CDs often range from 3 months to 10 years and beyond. I would recommend using bank CDs in the range of 1 to 5 years. Why? Simply because very short-term bank CDs less than 1 year tend to offer lower interest rates than savings accounts and money market accounts with less liquidity. Bank CDs greater than 5 years break the golden rule of using a savings account as an investment account. Why? Because a CD tends to provide a much lower interest rate than what you can make in an investment.
Bank CDs are very useful for saving for items or events that you will definitely not need until a specified date since they offer a slightly higher interest rate than the standard savings account. You can also use them as a back up to an emergency account. It can be a place where you can save additional money with minimal penalty, if needed, with a higher interest rate.
I would also like to mention brokerage CDs as a similar sort of savings instrument. These CDs operate in a very similar fashion to a bank CD. The big difference is that you can buy these CDs at a brokerage and collect many different CDs from many different banks in one place. These CDs are very good for people that need a large amount of liquid money and don’t want to have to worry about FDIC insurance limits for their money (250000 dollars- Not something for a typical resident to worry about!!!) You can also buy and sell the CDs prior to the due date at a loss or gain depending upon the changes in prevailing interest rates, something that you can’t do easily with a bank CD.
Short term treasury notes are also another option as a safe short-term savings mechanism. The going interest rate at the present time is 1.31 percent for a five-year treasury as of the date that the article is written. This interest rate tends to be somewhat lower than what you can get in an FDIC insured CD. So, I tend not to recommend them. But, it is also backed by the full faith of United States government and is unlikely to default. It is surely a safe means of capital preservation.
The final two less liquid savings options are closer to a hybrid between savings and investments since there is a slightly higher risk of default (meaning there is a theoretical risk that you won’t get all your money back). These include investment grade short-term municipal bonds and corporate bonds.
For the typical radiology resident, municipal bonds are not the greatest deal because they tend to issue a lower interest rate than the other savings interest rates. Moreover, you do not get the big benefit of the municipal bond, the ability of the instrument to be free from federal taxes. Most residents are in either the 15 or 25 percent federal tax bracket, so the advantage of buying these instruments is typically not there. You really need to be in higher tax brackets (above 35 percent) to take advantage of this instrument. At the current time, the median yield on a 5-year municipal bond ranges from 1.1-1.4 percent depending on the investment quality. If you figure, that the true interest rate including the tax benefit is somewhere around (1.1/0.85 to 1.4/0.75) or 1.29 to 1.86 percent, depending on the bond and your tax rate, there is not much benefit to this sort of bond and it has a very low but real risk of default.
Investment grade corporate bonds can be another interesting way to save money for a fixed period of time. The interest rates at the current time may be a touch higher than the typical high-interest bank CD. However, again there is a real but remote risk of a short-term high-quality company default. I would not recommend it at the current time.
Finally, I would briefly like to mention that there is also the option of short-term bond funds. The reason I don’t like this option for savings is that there is a real risk of loss of principal (albeit not by that much typically), breaking the rule of using savings as an investment.
The Bottom Line
The biggest take-home point is to remember savings are not investments and investments are not savings. Severe damage to your financial life can occur if you break this cardinal rule, even as a resident.
Also, there are multiple ways that you can put money into savings. For most residents, a checking account, money market account, and/or saving account make a lot of sense for the most liquid needs. In addition, I would recommend bank or brokerage CDs to those residents that don’t need their savings for a slightly longer period of time (between 1-5 years) and want to accumulate a slightly higher interest rate.
Well, that’s about it for a summary of pitfalls of savings vs. investments, and the basics of savings instrument. See you back here in a little while for part 2- Investments!!!