

By Tara Struyk on 3 November 2011 2 comments
Photo: keeweeboy

I recently wrote an article where I explained two basic financial tips that had helped me stay on track with my finances. It was pretty basic advice, but the email I got from readers was dominated by questions and remarks about my decision to use a 6% interest rate to calculate the potential return on monthly savings of $200. Just how, many people asked, do you propose I get a 6% return? The question underlies a fundamental misunderstanding about a key concept in finance — average returns. If you’re struggling to find a way to earn some interest in this ultra-low interest rate environment, read on to learn why 6% isn’t an unreasonable expectation, even now. (See also: 7 Banks Still Offering Great Interest Rates)

How Interest Rates Work

Right now, savers are lucky if they can find a savings account that yields more than a 1% return. That’s because the interest rate you receive in a savings account is determined by the rates set by the U.S. Federal Reserve. Right now, the benchmark interest rate (which represents the lowest interest rate that investors will accept on non-Treasury securities) is currently at a historic low of .25%. However, between 1971 and 2010, interest rates averaged 6.45%. In fact, in the 1980s, those who bought certificates of deposit got rates as high as 14%!

While we’re unlikely to see returns like those any time soon, rates fluctuate over time based on a number of factors. And, because the benchmark rate can’t fall much lower, it’s going to have to head back up at some point. So even if returns are pretty paltry in most low-risk investments right now, this doesn’t mean your average rate over time will be anywhere near as low as the returns you're getting right now. However, your odds are even better if you invest that money rather than save it.

Saving Versus Investing

If you understand how averaging works, you can see how your return over many years may be much different from the rate you are currently getting on your savings. However, while a savings account is a must in case short-term financial needs arise, larger amounts of cash should be invested. If you’re looking to maximize returns, a savings account isn’t the best place to park any funds you don’t need to withdraw in the near future. If you’re looking to earn more on your money, consider an index fund, mutual fund, or even a well-tended stock portfolio. You could lose money in these types of investments, so if you're not a pro, you should use them sparingly and consult a financial advisor. However, it's risk that dictates your potential for return; adding just a little to your portfolio can drastically increase your chances of a better return. And, just as in saving, time is a big factor. For example, if you stick that money in an S&P 500 index fund, you have a 55% chance of earning 10% in one year. Keep the money in for 10 years, and your odds are closer to 85%.

The Key to Better Returns

The key for investors and savers is not to worry so much about what the rate is right now, but to set up a habit of saving consistently and keeping that money invested. If people save and invest consistently over time, they will be able to maximize returns and minimize risk. So, just as past performance doesn’t indicate future returns, current returns don’t dictate your average return over time. When it comes to money, time is one of the most important factors; returns may be poor right now, but if you stay the course, you are likely to get a chance to make up for those low returns down the road.

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I think this blog should really help clear up some investment basics for people, the big one being: it takes time, and the more time you can commit to it, the less risk there seems to be involved. Your money really isn't going to work for you unless you invest it and take some risk, but investing doesn't mean you have to or should take big risks.

Guest's picture

This article would have been reasonable 5 years ago, but I must admit - it is incredibly untimely. The global financial instability; sovereign debt levels; stock market volatility; super-low interest rates; insolvency of propped-up banks...all of these suggest that any investment in securities, bonds, funds, etc...would not be recommended at this time.

I may sound like a prophet of doom, but the global markets are going to crash. This will be brought on initially by European banks being allowed to fail, thus reducing the balance sheets are many international banks and sending them down as well.

The United States, Japan, Greece, Italy (and many more) cannot pay off their debt and are in fact continually adding to it. Regardless of what the news networks and politicans say, these nations cannot simply inflate their currencies and grow themselves out of their respective quagmires.

My advice if you have some money knocking about:

1) If you are going to invest in commodities, buy precious metals which hold their value - gold, silver...
2) Do not leave your savings in the bank - inflation is constantly devaluing that money, so you actually lose money by leaving it there
3) Think about things of real value: if you have a house, consider getting an extension to add an extra bedroom - the price of raw materials will shoot up soon due to the irresponsibility of the Federal Research and the effort from all countries around the world to devalue their currencies. If you compare a few quotes, you'll be able to get a real bargain as work begins to dry up for contractors.
4) If you have got cash in the bank and it's in Yen, US Dollar or Euro - exchange it quickly before these all crash. At the moment you will still get a solid price. The Asean block is working together and although they'll be affected by the crisis, their currencies will hold value relatively well, despite efforts in the East the spir on growth by using inflation as well.