Why investment funds are much safer than savings accounts!

Many of us still bear the emotional scars of the global financial crisis.  We witnessed a collapse in real estate prices and one of history’s worst crashes in the stock market.  Above all, many of the world’s biggest and oldest banks went bust.  These are the banks where you and I keep our savings.  They lend us money to buy houses and cars.  And employers meet payroll from funds stored in corporate accounts.

If these banks had been allowed to fail the impact on our lives would have been catastrophic.  Or so we are told.  In the end, governments bailed out nearly all of the failing banks.  This allowed these failed institutions to keep on operating.  The banks could service loans and provide withdrawals.

Largest bank bailout in history!

This collective bail-out was the largest in history.  It covered multiple continents.  It required coordination between all of the world’s major central banks.  The bailout (known as quantitative easing) was so large it continued for years.  And most of the bailout money has not yet been repaid.

I worked for two of these failed institutions.  Two German banks that received bailouts from the German Federal Government.  My job changed from making deals to getting money back for the taxpayer.  It was not fun work.  But I was very successful at it.  I recovered all the money for all of my loans.  But this was a drop in the ocean.

The bailout is still going on…

There are billions in unrecovered loans out there.  And most of these will be recovered at a massive loss.  Up to 80% and 90% of loan balances will not be recovered.  Taxpayers will pay the cost. 

…how secure do you think the banking industry is today?

With this in mind, how secure do you think the banking industry is today?  With quantitative easing still not repaid it is unlikely that a bailout like this can happen again.  What if there is another financial crisis?  The banks have been thrown a lifeline but they are still in the water.

If you’re like most people I talk to you have a significant cash balance in the bank.  Probably you have thought about investing in the stock market.  But you are put off by the small print that stipulates, investments can go up as well as down. This makes potential gains seem not worth taking the risk.

Are banks safer than the stock market?

So, you keep your money in the bank.  It seems safer than risking everything in the stock market.  But is it safer?  Or is this perceived “safety” an illusion fostered by the mainstream media?  Because the chances are that you are losing money annually in your savings account.

The current US inflation is around 2% per year.  At the time of writing a standard 1-year Certificate of Deposit (CD) from Wells Fargo paid 0.10% interest!  That is 1.90% below inflation!  Or another way of looking at it, is that you will be earning negative 1.90% on your savings every year.  That’s guaranteed annual losses.

Inflation kills your retirement!

Even worse is that this does to your retirement fund.  For example, imagine that you have $400,000 in cash today.  You decide to keep it in a savings account.  You can contribute around $15,000 per year to your savings.  Let’s say you plan to retire in 20 years.  What happens to your retirement if you invest in a CD (like the one from Wells Fargo)?

Well based on the online financial calculator you will have $524,000 in 20 years.  That’s pretty disappointing.  But it gets worse when you compare it to what you could earn in a diversified fund. 

Let’s say you put your funds in a 60/40 stock and bond fund.  (That’s 60% of your wealth in stocks and the rest in bonds).  We’ll assume that you’ll invest your stock portion in an index fund tracking the S&P 500. Conservatively speaking, you might expect an average return of 8% over 20 years.

When we put this in the online financial calculator we find that you will have $2.55m in 20 years!  That’s more than $2m than you will get from keeping your money in a bank.  You might say that you lose $2m by saving your money in a bank.

What about stock market crashes?!

But what about the risk?  Doesn’t the stock market crash? Yes, it does.  But it also recovers. For example, the crash in 2008 was one of the worst in history.  Suppose you invested at the peak (right before the crash) and didn’t sell any stocks when the market crashed.  Where would you be today?

Well the S&P 500 has returned 8.28% since December 2007 (right before the crash).  So, if you invested the same amount as before over the same period you would now have £1.1m.  If you left it in a bank account (and let’s assume inflation equaled the savings rates), then you would only have $550,000.  This is half what you would get from investing in the risky stock market!

And the stock market didn’t get a bail-out the way the banks did.  Undoubtedly some individual stocks went bust.  But if you invest in a diversified portfolio of stocks and bonds you will be protected from the risk that some stocks will fail.

Banks definitely fail…

Many people had savings in banks that did fail in 2008.  Maybe you did.  A lot of big banks failed.  But they got government bailouts.  How confident are you that the government will be there to save your bank next time?

Why on Earth do banks fail?  What is the crucial difference between a bank and a stock?  The crucial difference is that banks are perennially insolvent.  The average public company trading on the S&P 500 is not insolvent.  If it was, it would quickly become bankrupt.  Probably it would be front page news.

How do banks survive insolvency?

But why doesn’t being insolvent mean that banks immediately go bust? And how are they insolvent?  They are insolvent because they borrow short and lend long.  In other words, they take from you a demand deposit.  When you put your savings in the bank, usually you can take it out any time you want.  Maybe the same day or maybe within a month.  It depends on the nature of the savings account that you have.

However, the bank doesn’t usually lend for only 24 hours.  They lend for anywhere from a year to 30 years! And it lends the money that you deposit.  The bank is betting that not all of its depositors will show up to reclaim their money at the same time.  Because if they do, the bank will not have the money available to pay everybody back.

In practice, people do not do this.  They deposit their paychecks regularly.  They spend that money (on bills, rent, mortgage payments, etc.) in a predictable fashion.  This means that banks can be reasonably sure that not every depositor will show up at once.

The cause of bank runs…

So what causes everyone to run to the bank at once?  It is when rumors of the banks liquidity problems start to surface.  When a bank is having trouble then savers become very nervous.

For example, in 2008 Wachovia bank was over-exposed to the subprime mortgage market.  When people began to default on these mortgages Wachovia made serious losses.  This made depositors nervous so they began drawing down their balances to below $100,000.  $100,000 is the limit for FDIC Deposit Insurance.

What about deposit insurance?

Now lest you think that FDIC Deposit Insurance keeps your savings safe consider the following.  Wachovia lost 1% of its deposits in one day (Friday).  This may not seem like a lot.  But this relatively small loss meant that they didn’t have sufficient funds left to open for business on Monday! 

In this case, the bank run would become catastrophic.  And the FDIC might not have had sufficient money itself to make all of the insurance payments!  This in turn could lead to more bank failures as banks tend to be exposed to each other.

Fortunately, a deal was struck with Citigroup to lend Wachovia enough money to stay afloat.  And later, Wells Fargo bought Wachovia.  Wachovia was just one of many failing banks.  So, consider, do you really want all of your money in such an institution?  Do you want your money at the mercy of a government engineered bailout?  And be earning negative interest for all of this risk?

Maybe the stock market is safer than savings accounts…

Or does it appear that the stock market is a safer bet after all?  You can buy 500 or more stocks at one time.  There has never been a case when all of the stocks on the S&P 500 have failed.  Combining this investment with bonds gives you excellent diversification.  And the returns will be significantly higher than what you will lose frankly, in savings accounts.

Banks cause recessions…

I could go on and on about banks.  For example, because of their very nature they cause inflation and recessions.  How does this happen?  It is because when you deposit money they turn around and lend it to someone else.  Let’s say that you deposit $100.  And then the bank lends $50 of that money to a business owner.  That business owner will deposit that loan into his account. 

The business owner will now have a deposit account with a balance of $50.  But you will also have a deposit account with a balance of $100.  So, the bank has inflated the money supply by $50!  And then the business owner’s bank will then lend out a portion of his $50.  But this is fake money!

You can probably now see where this is going.  All of these banks are inflating the money supply.  This reduces interest rates (interest rates are the price of money).  More money means that it becomes cheaper.  And so, businesses are motivated to borrow more money.  They invest this money on projects that otherwise they would have not had the money to begin.

Later these projects fail.  Think about car manufacturers building cars that they could not afford without this fake money.  Nobody really wants these cars.  So, they do not sell.  Because the cars do not sell the car manufacturers cannot repay their loans.  They go bust (like General Motors in 2009).  Lots of companies go bust at the same time.  And you have your recession.

Government rescues banks but not you…

To add the insult to injury, the Government will then bail out the failing banks.  They are failing because their customers are now bankrupt.  This bailout further depresses interest rates and increases inflation (meaning that prices go up).  So, you are now earning negative interests on your savings.  The negative interest rate effectively pays for the bailout.

So, I ask you, do you really want your money in such an organization?

How to buy alternatives to savings accounts.

Assuming I have convinced you otherwise, you may be wondering how exactly you buy alternative investments to savings accounts.  How can you safely find investments that will beat the bank’s rate?

If you have read my previous articles then you will know understand the Investment Framework.  In summary it is:

1. Define your goals and how much they will cost
2. Calculate what return you need
3. Determine what your risk tolerance is
4. Figure out what your constraints are (time horizon, liquidity needs, taxes, legal and regulatory, unique circumstances)
5. Choose the assets you want to invest in
6. And calculate how much you want to or can contribute

So, the next step is actually to place your money in the appropriate investments.  Generally, I find that most people want a mix of stocks, bonds and real estate.  The easiest and quickest way to access these investments is through funds.  Funds will give you the diversification benefits that I have discussed in other articles.

What type of fund is best for you?

There are many types of funds you can invest in, including active and passive funds.  Active funds are managed by fund managers who try to “beat the market”.  In other words, they try to earn a return significantly higher their benchmark index (like the S&P 500 for example) for that particular year.  A passive fund would merely track the index.  It would do this by buying all of the stocks in that index.

Generally, the accepted view is that passive funds perform better than active.  But you should invest in the type that you are comfortable with.  If you don’t know, err on the side of passive.  It can be very difficult to figure out the performance of active managers.  And also, active funds tend to be much more expensive.

Look out for management fees!

With almost any fund there will be a management fee.  I have seen management fees as high as 2% for active funds.  With passive funds they can be as low as 0.03% or 3 basis points.  So, if you invest $1m in an active fund you will pay an extra 1.97% per year or $19,700 for the first year.

If we go back to the earlier example where you invested $400,000 for 20 years then your ending portfolio would be valued at $1.8M.  This means you have paid $750,000 over 20 years!

We are assuming here that active funds actually match the performance of the market.  However, the evidence is that they underperform the market over the long term.  That means that on top of paying these management fees your ending portfolio will probably be significantly less than $1.8m.

However, there are still lots of passive funds out there.  How do you choose?  Well recall that the biggest risk decision that an investor can make is the allocation between stocks and bonds.  To play it safe, most investors will choose an allocation of between 40-60% stocks and 60-40% bonds.

What does Warren Buffet say?

Warren Buffet suggests that you simply choose a fund based on the S&P 500.  As he suggests, this is basically an investment in the future success of American business. You could simply have 60% of your portfolio in the S&P 500.  This is a good start to get used to the process.  Later you can diversify into UK, European or Global stock markets.  But one step at a time.

For the bonds you could invest in one other fund.  The Motley Fool suggests the Schwab U.S. Aggregate Bond ETF as it tracks a wide-ranging index of U.S. investment-grade bonds.  What are investment grade bonds?  They are bonds with a low probability of default.  In other words, very conservative.  Coupled with the diversification benefits this makes for a low risk investment.  And it will return a higher rate than your savings account.  The opposite of investment grade bonds is junk bonds.  These have a high risk of default.  It is best to avoid these unless you really know what you’re doing.

Are there funds for real estate?

Now some people are really interested in real estate.  However, when most people think of investing in real estate they think of buying a house and renting it out.  This is the hard way.  Think about the time you will spend viewing houses; exploring the market; hiring lawyers; completing mortgage applications; hiring letting agents; managing tenants and so on.

Why not have someone else do all this hard work for you?  After all, most people have no idea what their return is from renting a house.  They do not account for all of the expenses, maintenance, refurbishment costs, etc.  They do not account for inflation.

Real estate funds work like stock funds.

There are lots of real estate investment funds out there.  Here you will know exactly what your return is.  And you won’t have to do all this hard work.  Investing in a real estate fund is as easy as investing in an index fund.  They have passive and active funds.  And they can be diversified across different property classes (such as office, retail and residential).  They can also be diversified geographically across cities, states and globally.

Some of the same providers of index funds also provide Real Estate Investment Trusts (REITs).  Companies such as Vanguard, Schwab and iShares for example.  However, there are many others.  The key here is that you will always know what your return is.  It will be calculated by professional fund managers.  But who will calculate your return on your rented house?

Diversification can be achieved with real estate.

Also, with a single rented house you have no diversification.  All of your investment is in one property.  If something goes wrong there you could lose everything.  So effectively, you have much higher risk with an uncertain return.  That doesn’t sound good to me.

If you have dreams of owning multiple investment properties don’t let this put you off.  But it is best to start slowly.  Learn the market.  Invest in a real estate fund and see how it goes.  As you gain knowledge and understanding maybe later you can buy an actual property.  You can use some of the money you have made from your other investments.

Investing in a fund is like opening a bank account

Investing in these funds is a bit like opening a bank account:

1. Decide which funds you want
2. Determine what allocations you want
3. Go to the company’s website and open an account
4. Place your money in the relevant funds
5. At the end of every year check your fund statements for your returns

This is how you will beat the banks rate!  You can also buy these funds at your local bank.  Generally, this is a bad idea because you may have to pay the bank a fee.  Usually, its best to go direct to the fund provider.

Personally, I set my own allocations something like the following:

Investment	Percentage Allocated
Stocks	40-60%
Bonds	40-60%
Real Estate	5-10%

 

In addition, as I have mentioned in previous articles, I also keep an emergency fund (in gold and cash) of about 6 months living expenses.  And I also have my aspirational portfolio.  That is this business in which I am teaching people like you how to invest.

In my next article I’ll tell you about one of my clients who applied what he had learned.  If you do have any questions about what I have discussed here, please reach out to me.  I’d love to hear from you!