Why Savings in the Short Term and Other Investments for the Long Term?

Tammy writes in:

You often tell people to put money in their savings account if they’re just saving for a year or two, but then you tell people to put money into stocks or other stuff if they are saving for lots of years. Why?

It’s probably easiest to explain this with an example.

Savings Accounts
Let’s say that, at the start of each year, you put $1,000 into a savings account. This savings account keeps your money safe and pays out 1.5% interest per year.

After the first year, you’ll have $1,015 in the account.
After the second year, you’ll have $2,045.23 in the account.
After the third year, you’ll have $3,090.90 in the account.
After the fourth year, you’ll have $4,152.27 in the account.
After the fifth year, you’ll have $5,229.55 in the account.
After the sixth year, you’ll have $6,322.99 in the account.
After the seventh year, you’ll have $7,432.84 in the account.
After the eighth year, you’ll have $8,559.33 in the account.
After the ninth year, you’ll have $9,702.72 in the account.
After the tenth year, you’ll have $10,863.26 in the account.
After the eleventh year, you’ll have $12,041.21 in the account.
After the twelfth year, you’ll have $13,236.83 in the account.
After the thirteenth year, you’ll have $14,450.38 in the account.
After the fourteenth year, you’ll have $15,682.14 in the account.
After the fifteenth year, you’ll have $16,932.37 in the account.

What’s worth noting here? First, the money is growing all the time. There is no point where the money’s not growing. There is no point where the growth is less than the year before. It’s steady, positive growth.

At the same time, it’s slow growth. You’re not seeing a skyrocketing increase in price over time. It’s going up steadily, but slowly.

Stocks
Let’s assume you put $1,000 into the Vanguard 500 (a broad-based stock market index) each year on the first trading day of the year, starting on January 1, 1996, and choose to reinvest the dividends. Here’s what happens with your money.

At the end of the first year (1996), you’d have $1,299.68 in the account.
At the end of the second year (1997), you’d have $2,996.43 in the account.
At the end of the third year (1998), you’d have $5,402.76 in the account.
At the end of the fourth year (1999), you’d have $7,231.63 in the account.
At the end of the fifth year (2000), you’d have $8,260.74 in the account.
At the end of the sixth year (2001), you’d have $7,862.39 in the account.
At the end of the seventh year (2002), you’d have $6,946.30 in the account.
At the end of the eighth year (2003), you’d have $10,862.61 in the account.
At the end of the ninth year (2004), you’d have $12,851.47 in the account.
At the end of the tenth year (2005), you’d have $15,573.23 in the account.
At the end of the eleventh year (2006), you’d have $19,308.22 in the account.
At the end of the twelfth year (2007), you’d have $20,217.50 in the account.
At the end of the thirteenth year (2008), you’d have $12,748.24 in the account.
At the end of the fourteenth year (2009), you’d have $18,745.44 in the account.
At the end of the fifteenth year (2010), you’d have $24,531.96 in the account.

While the overall growth upward is better than with the savings account, the stock investment is wildly uneven. There are individual years that are devastatingly bad, and the problem is that you can’t predict those devastating years. Your first year of investment might have been 2001, where you would have put $1,000 in at the start of the year and seen a balance of substantially less than $1,000 at the end of the year. You might have been planning to pull the money out at the end of the thirteenth year, except that thirteenth year saw a 40% drop in the balance and finds you in significantly worse shape than a simple savings account.

What Does All This Mean?
It’s actually pretty simple. If the date at which you’ll need the money is a long way off (say, fifteen years or more), the overall growth of things like stocks is the best route. Because you’re looking so far down the road, those individual bumps really don’t matter too much. You can live through another 2001 and 2002 or another 2008 if you’re looking fifteen years down the road or more.

On the other hand, if you know you’re going to need a certain amount in the next few years, you should have it in a savings account (or something else that’s highly reliable). It won’t provide rampant growth for you, but it will provide stability. You won’t lose your balance this way and you won’t find yourself in a situation where you need the money and it’s lost in a stock market collapse (in fact, people often need money when the stock market is down, as that’s a time when the economy is trending down, too, and there are job losses and so forth to worry about).

What if you’re in the middle? Have some of your money in each. As you get closer, move your money from the risky investment (stocks) to the less risky one.

Another vital point is that you should never try to time the market. Base everything on when you will need the money. If it’s a long time off, ignore what the market is doing this year. As your goal inches closer, slowly move the money into something more secure, regardless of what the market is doing at that moment.

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10 thoughts on “Why Savings in the Short Term and Other Investments for the Long Term?

  1. Adam P says:

    Canadian perspective here. I earn 1.5% before tax, about 1.1% after tax in my high interest savings account I use for my house downpayment fund. Inflation is 3.3% as of March. So I’m losing 2.2%. Housing prices are going up about 4% to 8% a year lately (Toronto market), could be more or less depending on who you listen to.

    I’m thinking a short term bond fund seems to be about the best combination of outpacing inflation (savings account problem) and less volatility (stock markets). If interest rates go up suddenly, my bonds will be worth less, but so will house prices (in theory) as the mortgage would be too expensive otherwise since wages are going up slower than house prices.

    But you ignore bond indexes in your analysis completely? What’s the reason there? It just seems so straw man to pick the most conservative (savings account) and compare it to a high risk portfolio(100% equity). Where’s the middle man?

  2. Johanna says:

    If you’re using actual stock-market returns, you could also use actual savings-account returns. The interest rate on the savings account is not going to stay constant at 1.5% for 15 years.

    In addition to the time scale of what you’re saving for, how flexible your goal is is another important factor. If you’re saving to buy a house in three years, but you don’t mind pushing the purchase back to four years or five years, it may be appropriate to put some of the money in something riskier than a savings account.

  3. Troy says:

    Nice comparison. Historical data for the market, and some made up obscure 1.5% current value for the “savings account”

    You could have taken the historical 1 yr average CODI of 4.09% as a comparison, but that would weaken the argument and case, and therefore point out the flaws of the post.

    Using the actual historical rates of return the savings account would have actually grown to nearly the same figure…about $23K after 15 years. And it was ahead for most of the time until the very end of 2010. All with zero risk and fully insured.

  4. Andi says:

    How did you figure the interest in the savings account example?! At 1.5% interst, there is NO way you’ll earn $1000/year! I’ve taught high school math for years and the standard compound interest formula is A= P(1 +r/n)^n*t where P is principal, r is the rate as a decimal, n is the number of compoundings per year and t is time in years.

    I worked with your numbers and after the first year, I agree, you’d have $1015.10 but after the second year, you’d have $1030.44 NOT $2045.23. I used your interest rate and figured 12 compoundings a year where many banks only figure interest quarterly.

    You might want to check your calculations and I’m guessing that a correction is probably worth posting on this one.

  5. Andi says:

    I’d like to apologize – I missed the “you add $1000 at the beginning of each year.” My reading skills are lacking this morning. Still a good idea to explain your calculation though for others to repeat.

  6. Justin says:

    My wife and I were just talking about this yesterday.

    We put some of our money into a pretty secure mutual fund (CDs and bonds) that returned 6% last year. That’s for our short-term goals (buying a house int he next few years)

    The rest of our saved money went into our ROTHs. That’s for the long term stuff.

    Like I was telling her, we might see faster growth if we threw everything into higher risk mutual funds, but we’d be sad if the market tanked again right before we bought a house and needed the money.

  7. Robert says:

    He’s rodent-like. Rodentus mathematicus.

  8. krantcents says:

    I think you need a combination of fixed, growth, dividend, and more in your asset allocation of your investments. This would include real estate, and multiple income streams as well. It is a reasonable way of making sure you have a nest egg for your future retirement.

  9. Evita says:

    I wish Trent would have disclosed that the 15-year inflation rate in the U.S. is 43% ….. google cpi inflation calculator to see the horrible numbers…..

    Adam P: you can open a tax-free savings account or get a short-term GIC with a (slightly) better interest rate (check ING). Given the inflation rate, every cent counts !!

  10. Tom says:

    Agree with comments 2 and 3, If you’re going to use real market returns, you should’ve taken the time to look up real savings account returns (not an arbitrary 1.5%)

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