Over the weekend in a post answering anonymous reader questions, I wrote the following:
Savings accounts are wonderful places to keep money that is very liquid (meaning you can get it if you need it) and earns a small rate of return with very little risk. Because of these factors (liquid, low risk, some return), they are great places to store emergency funds, which is a fundamental part of any personal finance strategy. An emergency fund is a buffer to prevent budgetary disaster in the event of a personal crisis.
This inspired the following question from a very faithful reader who sent me an IM less than five minutes after that article was posted:
It seems to me like it is always good to put your money in a savings account that earns 5% like HSBC Direct. Why would you do anything different?
As I mention, there are indeed a lot of advantages to savings accounts. You can get at the money at your convenience, it can make a nice return in the right account (HSBC Direct, for instance, has a 5.05% APY and some smaller banks do better than that), and there’s very little risk as the account is insured by the FDIC up to $100,000. It is without a doubt a stellar place to put your cash that you may need in the short term.
However, once your savings reaches a point that is out of the reach of your emergency fund needs (at least a few months’ worth of salary), it’s time to start looking for a place to put your money for the long term. For example, the Vanguard 500 has returned an average of 12% a year since 1976, but that return isn’t guaranteed year in and year out – some years have had a net loss, while others have had returns far above 12%. It’s still reasonably liquid in there, but you can pull out at any time (we’ll not get into the taxes on your gains here, but at most you’ll have to pay the same rate as your normal income and it may be substantially less than that). There are many real estate investments that can return spectacularly, too.
Why do this? The potential returns are too good to pass up. If the Vanguard 500 continues along at the historical rate, the money in it doubles every six years, while in a 5% savings account, your money doubles roughly every sixteen years. Let’s say you put a dollar into the savings account and a dollar into the Vanguard 500 and waited 20 years. The savings account would have $2.65 in it, but the Vanguard fund (if it continues at the historical rate) would have $9.65 in it. Multiply those by a thousand or ten thousand and you’ll see why it’s a big deal.
So why not just invest everything in the Vanguard 500 or another investment if it returns that kind of money? The reason is that it’s not insured and it’s far from a guaranteed return. There have been many years where the Vanguard 500 has lost fistfuls of money (the returns from 2000-2002 were positively nightmarish, with 20% losses) – the positive numbers are only over the long term because the good years overall outweigh the bad. On the other hand, a savings account won’t lose its value – it will just stay there and chug along quietly for you, keeping your money quite safe for you.
In other words, keep enough in the savings account so that your short term needs and emergencies can be met, then take the rest and play with it for the long term by investing it somewhere.