Saving in a low-yield world
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Should savers break rules?

Investors who have taken a shellacking in their investment portfolios over the past year can be forgiven for sitting on the sidelines in cash while tending their wounds.

Unfortunately, cautious savers are having a tough time getting a reasonable return on their money. Rates have fallen as a result of the Federal Reserve's decision to try to jump-start the economy by holding the targeted federal funds rate at the lowest level possible.

With rates so low, many savers are reconsidering how and where they save while asking themselves the following question: "Should I buck or heed conventional savings wisdom right now?"

In deciding where to hold your cash, it's a good idea to think through the financial goals you're trying to accomplish. Use those goals to guide you into the savings vehicle that is right for you.

Savings vs. investments

Before delving too deeply into the topic, it's important to make a distinction between savings and investment. It's not that there's no overlap between the two terms, but distinguishing between savings and investments can help consumers make better decisions about how to put their money to work.
  • Savings. Preservation of principal is the top priority for savings. The choice of where to save money depends on the importance placed on four different attributes associated with the savings account: risk, convenience, liquidity and yield.
    There's a difference between risk to principal and purchasing-power risk. Principal can be perfectly safe, but purchasing power can erode from the impact on inflation over time.
  • Investments. By contrast, the goal of investing is to achieve a positive real return over time. Investors want their principal back, just like savers. However, investors balance a more complex bundle of risks, including purchasing-power risk.

"This time it's different," are the four most expensive words in the investing language, according to Sir John Templeton, legendary investor and philanthropist. It's worth keeping this famous investor's wise words in mind when deciding on a savings strategy, too.

The following are some tips for regarding conventional wisdom in structuring a savings plan. Remember, there's no one right answer, but there is an answer that's right for you. That's why it's called "personal" finance.

Second look at savings
  • Emergency funds
  • CD laddering
  • Retirement plan choices

Emergency funds

Conventional wisdom says consumers should build an emergency fund that has three to six months of living expenses held in liquid savings -- typically a money market account -- although a savings account can work, too.

With the unemployment rate topping 9 percent, bucking conventional wisdom could have you increasing the size of the emergency fund to six to nine months of living expenses. Setting aside that much money in a liquid account poses a dilemma. Yes, it provides extra money you can use in an emergency. But ideally you'll never need that cash; meanwhile, it's earning a low yield.

The middle of a recession could be considered the wrong time to buck conventional wisdom when deciding how to invest an emergency fund. However, a willingness to take on some risk with the money can improve its yield.

Holding your emergency fund money in term CDs is one way to improve yield. CDs generally offer higher rates of return than savings accounts.

A recent check of Bankrate's Compare Rates feature revealed the highest national rate available for a five-year CD was an annual percentage yield of 3.5 percent. This compares to the highest APY available on a money market account, or high-yield savings account, of around 2 percent. That's a difference of 1.5 percent.

The risk of keeping money in a CD is that you will need the money early, which would trigger an early withdrawal penalty. Such penalties typically result in the loss of some interest, not principal. I say "typically" because there could indeed be some risk to principal in some circumstances -- for example, if you buy a five-year CD only to need the money next week, and the early withdrawal penalty is six months' interest.

Like all savings decisions, the saver needs to strike a balance between safety, convenience, liquidity and yield. But you can effectively eliminate the safety issue by holding savings as a deposit insured by the Federal Deposit Insurance Corp. or the National Credit Union Share Insurance Fund.

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Conventional wisdom would have you pay down credit card balances before building up a cash cushion. Bucking conventional wisdom has you building the cushion first, even if that means paying the interest expense on the credit balances. That doesn't mean running up credit balances in order to build savings. To make this approach work, you have to be living within your means.

It sounds obvious, but having a cash cushion for emergencies can help your credit score. Without a savings cushion, you may need to run up your credit balance in a financial emergency, which sends a negative signal to creditors. The creditors could use your higher balance as a reason to raise the interest rate on your cards. Holding high balances at 25 percent to 30 percent interest will just amplify any financial difficulties you experience.

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