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Should savers break rules?

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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.

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.

CD laddering

The intent of CD laddering is to invest your savings over a time horizon, rather than trying to lock in longer maturities when rates are high or staying in shorter maturities when rates are low or likely to head higher.

When you ladder, it’s the CD equivalent of dollar cost averaging in the stock market, with one important difference — with a CD ladder, savers typically put all their money to work at one point in time, and then reinvest the money when a CD matures.

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A five-year CD ladder would include everything from a money market account with some cash to CDs of various maturities up to five years. Each maturity is like the rung on a ladder. Unlike a real ladder, the distance between rungs doesn’t have to be symmetrical.

Conventional wisdom would have you use the same-size ladder regardless of your feelings about interest rates. The whole idea behind laddering is to discourage savers from trying to time the market. Instead, savers purchase a new CD out to the end of the investment horizon each time a CD matures.

Bucking conventional wisdom makes sense here. That’s because a typical CD ladder is initially purchased all at once, and because, with interest rates at or near historically low levels, there’s really not much of a chance that rates will continue to head lower.

One approach that goes against convention is to build an extension ladder. Start with a shorter-term final maturity that is less than your investment horizon. Build that shorter ladder, but as CDs mature, extend farther out than your initial final maturity.

For example, let’s say the initial CD ladder is three months to two years. Using the “extension ladder” approach, you’d wait for the first CD to mature and use the proceeds to buy a 2.5-year CD. Take this approach until your ladder extends out to your long-term investment horizon.

You can learn more about CD ladders by reading the Bankrate feature “Laddering: How to build a CD ladder.” Try your hand at laddering CDs and see what your return will be with Bankrate’s CD ladder calculator.

Retirement plan choices

Retirement account asset allocations should not be the same for every investor. Allocations vary depending on how close the account holder is to retirement, the investor’s attitude toward risk and the investment options available in a retirement plan.

Conventional wisdom has early career, and midcareer investors allocating high percentages of these retirement assets to stocks. Stocks provide a better hedge against inflation than bonds or money market funds, and younger investors traditionally have been encouraged to take on more risk, as their relatively long investment horizon allows for “rebuilding years” should the market take a sudden plunge.

However, the industry now is struggling with the whole concept of “rebuilding years” at a time when the average annualized return on the S&P 500 stock index has been negative over the past 10 years — approximately 1 percent negative annually through July 31, 2009.

That’s not a reason for workers to turn their backs on investing in retirement accounts, especially if the firm has a program where it will match a portion of the worker’s contribution to the account. A typical plan contributes 50 cents on every dollar contributed up to maximum employer contribution of 3 percent of salary. Don’t turn away from earning up to a 50 percent return on your money.

If you are dissatisfied with recent returns, do some forensic work about what went on in your retirement portfolio and the changes that need to be made. That could include lobbying the plan provider for investments with lower annual fees and expenses. It could also include lobbying for other savings and investment options.

Remember, retirement accounts are just part of an investor’s total financial picture. Consider integrating retirement monies into a holistic approach to wealth management. Get the big picture by working with a fee-based financial planner who can help map your life goals and how your finances can help you reach them. Part of the process will involve finding an asset allocation that’s right for you.