The current low-interest rate environment might make buying a home or car attractive, but it makes growing your money a challenge.
With average rates for savings and money market accounts at 0.12% and one-year CDs at 0.69%, according to Bankrate.com, it’s hard to keep up with inflation, which was 1.6% in January.
Chasing yield, which means choosing to invest in riskier assets or securities to gain extra yield or return, can expose your portfolio to additional risk but it’s easy to fall behind inflation unless you consider alternative investment strategies.
“It’s a very dangerous time to chase yield so you really need to understand investments,” says Scott Sprinkle, a certified public accountant in Littleton, Colo. He says when rates are low, any small incremental yield isn’t worth the risk of principal loss.
“Your safest investments across the board, whether its treasuries, CDs, fixed deferred annuities or savings bonds, [have] yields [that] are extremely low,” says Jon Thompson, senior wealth manager at USAA Wealth Management. “Yield is not very reactive for safe investments.”
Emergency funds or money intended for use in the next few years to buy a home or for retirement needs to be in safe investments like FDIC-insured accounts, experts say. “Any money that you need in the next six to 12 months should be in cash—you can’t take risk with that money,” says Sprinkle.
When it comes to long-term investing, you need to be more aggressive and active to make your money grow in this environment. “Having a diversified portfolio for money slated for long-term goals that are more than seven years out is a good thing,” says Thompson.
As you look to diversify into stocks and bonds, experts suggests knowing your personal tolerance for risk and understanding how interest rates can affect your investments.
Why Interest Rates are so Low
Interest rates reflect an investment’s return while inflation is tracked by an index of prices, explains Thomas Cooley, professor of business and international trade at Leonard N. Stern School of Business at New York University.
To spur lending and help the economic recovery, the Federal Reserve has been keeping the federal funds rate low. “The Fed is trying to keep expectations of inflation low by keeping rates low for the foreseeable future,” says Cooley.
Although there’s no guarantee that the Fed won’t change its plan, experts expect rates to stay low through the end of 2014.
“Inflation affects investments in different ways,” says Thompson. “Inflation causes rates to go up and bond prices to go down. However, for the portion invested in stocks and equities, we would expect them to be appreciating and growing in inflationary years.”
The Fed has stated that it intends to keep rates low until unemployment numbers improve. “Within the next one to two years, you’ll start to see a steady increase in rates,” says Thompson.
What are Your Investment Options?
“If you’re a saver, you’re faced with this incredible dilemma,” says Jonathan Clements, director of financial education for Citi Personal Wealth Management. “We’re looking at a minimum of two more years of rock bottom rates on savings accounts and CDs.” Anyone wanting a higher return on investments will most likely have to take on more risk.
As an investor, you can decide to go longer out the risk spectrum in bonds or put your money in dividend yielding stocks, says chartered financial analyst Robert Stammers, director of Investor Education for the CFA Institute. “Are stocks less risky for you than if rates rise and you wipe out profits in your long bond portfolio? That’s a personal choice.”
Here’s what experts have to say about different investment strategies in the current environment:
CD Ladders. Thompson suggests considering CDs with varying maturity to offset any risk that your investment value will change because of interest rate. To do this, create a CD ladder by buying CDs that mature one, two and three years from now.
“When the CD matures in a year, you can invest that money in another three-year CD with a better rate.” He says this strategy helps to preserve capital and capitalize on rising rates.
Treasuries and bonds. There’s an inverse relationship between bond prices and interest rates—when rates go down, bond values go up and your investment value increases, explains Thompson. Rates can only go up in today’s interest rate environment, driving bond values down and causing a principal loss in your investment.
“In terms of taking more risk, if people have a yield orientation and are dissatisfied with CD rates, if you look for the highest possible yield in the bond market, you’ll end up with a lot of risk because you’ll end up buying low quality bonds or longer term bonds,” says Clements.
Variable investments may seem tempting because of their return, but it’s important to understand the risk that’s involved, warns Stammers. In order to get yield, you may have to buy a bond with more credit risk and a higher probability of default.
Treasuries or bonds with long maturities may be tempting in this rate environment, but if rates go up and you have to sell your bond, it will most likely be at a discount, meaning you lose a portion of your investment, says Stammers. “People need to realize the return they’re getting for the risk involved. Long bonds are risky—there’s not a lot of return and small increases in interest rates can wipe out any investment gains.”
Stocks. To create a diversified portfolio, experts recommend investing in ETFs or mutual funds rather than individual stocks. “If you’ve time on your side and you over allocate to equities, if things go bad, you have time to make up for something that goes wrong,” says Stammers.
Always do your research before buying a mutual fund though, says Thompson. “There are lots of factors that go into that analysis.” He suggests comparing a fund’s performance to its peer group during a long and short time period. If it’s outperforming its peers, look at how much risk the fund has to get that return, suggests Thompson.
A mutual fund’s costs, management tenure and third-party rankings are important factors for your decision to invest. Thompson recommends funds having management with a proven track record rather than one with a lot of turnover.
“Pay attention to cost and whether there are sales commissions or loads—costs associated with buying and selling the fund,” says Thompson. He also suggests investing in funds with low expenses.
While ETFs don’t have active portfolio managers, they’re good options if you’re looking for specific exposure to a sector or industry, says Thompson.