In the years since the financial crisis hit, many have been extremely reluctant to invest in stocks or bonds. The markets have since recovered and then some, but the memories of such sudden and frightful losses are enough to keep some investors on the sidelines.
These individuals prefer safe investment vehicles like savings accounts and bank certificates of deposit. And these investments are certainly risk-free in the sense that they usually carry FDIC insurance. But there's a separate risk investors need to know about before they put their money in low-yielding products. That is, if the interest rate is less than the rate of inflation, your purchasing power is eroding, and you'll risk outliving your savings.
That's why investors need to know there's no such thing as a truly "risk-free" investment.
The cost of "safe" products in a low-yield environment
Savings accounts and certificates of deposit with federally insured banks seem like great places to put away money in uncertain times. Indeed, so long as the financial institution in question is insured by the FDIC, savers' accounts are fully backed by the federal government up to $250,000 per depositor, per insured bank. The protected account types include checking accounts, savings accounts, money market deposit accounts, and certificates of deposit.
This protection is hugely valuable -- there's no doubt of that. The FDIC says no depositor has lost a single penny of FDIC-insured funds since the agency's establishment in 1933. But this safety also comes with a cost -- one investors should consider right now. We are currently in an extremely low-rate environment, which means most federally insured account types provide little to no interest.
For example, according to Bankrate, checking and money market accounts provide virtually no yield. Certificates of deposit are better, but not by much. A one-year CD carries an average interest rate of less than 1%. Even delving into lengthier maturities doesn't help a whole lot: Bankrate recently estimated that five-year CDs yield an average of just 0.82%.
Think about the costs of such a low-yielding product for that long. If you invest $10,000, earning 0.82% per year, you'll wind up with just $10,417 after five years.
While that may strike you as a satisfactory return, it's only one side of the equation.
The ravages of inflation
The other major consideration for those socking away money in low-yielding products is purchasing power. Purchasing power essentially describes what a dollar can buy from one year to the next. When inflation hits, a dollar isn't worth as much over time. Inflation during the 12 months ended in August was 1.7%, and the U.S. Federal Reserve maintains a target rate of inflation of 2% per year over long periods of time.
With interest rates so low, products that yield less than the target rate of inflation will actually see negative real yield. If inflation is at 2% per year and you invest in five-year CDs yielding the average of 0.82%, your purchasing power will actually decline by 1.18% per year, because those CDs' returns won't keep up with inflation. And if the time horizon in question is long enough, you risk outliving your savings.
That's why, despite the understandable urge to seek maximum safety in uncertain times, investors need to consider the true cost of every investment. While stocks and bonds carry higher risk levels than bank products, the average returns over long time periods are consistently higher.
Until interest rates rise, those exclusively choosing savings accounts, CDs, and other FDIC-insured products will have to be content with declining purchasing power in exchange for the safety of principal protection.
