Michael writes in and asks:
I am planning to eventually get my PhD in 4-10 years. Should my savings be in a high-yield savings account or is there a significantly better place to put it with a little more risk but not as risky as an index fund?
An index fund is about as low risk as you can get in the stock market. A broad-based low-fee index fund simply invests in a huge portion of the stock market and just rides the whole thing, minimizing the risk by investing in thousands of companies simultaneously, some of which will skyrocket, some of which will tank, and some of which will just float along calmly.
Onto the bigger question, though: how does one invest for the intermediate term? Stock investments work best over the long term, because the peaks and valleys will average themselves out – if you invest for just a few years, you may hit a valley and lose some serious coinage. On the other hand, cash investments work best in the short term – you can earn 5% very easily with cash (HSBC has a 5.05% APY savings account, for example).
Let’s look at a few investment options for $10,000 over the intermediate term (say, five years). I’m sticking with simple options, ones that allow the investor to merely put in money, leave it, and not worry about micromanagement; I’m also skipping over investments with a high level of risk:
A savings account Let’s say you put $10,000 into HSBC Direct and just sat on it for five years. It would earn a 5.05% APY and after five years, you’d have $12,788.93. A big advantage here is that the investment is almost risk-free – the only things that can happen is that HSBC lowers their interest rate (at which point you could move to another investment). Another big advantage here is that the cash is completely liquid – there’s no penality for withdrawal at any time. Given that a treasury note can’t currently match this level of return, we can pretty safely discard treasuries for investment at this time.
A CD Many banks offer certificates of deposit with rates up to 5.60% APY. At that rate, a five year CD would give you $13,124.34 at the end of five years. A better return than the savings account, but it has the disadvantage of being rather illiquid – you’d be hard-pressed to get your money out.
An index fund I’m going to use the Vanguard 500 as a model here as it is a great long-term example of an index fund. Let’s say, for example, that you put $10,000 into the Vanguard 500 on January 1, 1996 and then withdrew it on January 1, 2001. Your $10,000 would be $23,211.44 – a return that is pretty hard to beat over a five year period.
On the other hand, let’s say you put $10,000 in the Vanguard 500 on January 1, 1999 and then withdrew it on January 1, 2004. Your $10,000 would be worth $9,466.44 – you could have had thousands more with the money in a savings account.
Over a given term of five years, the stock market, even in a relatively safe index fund, is too risky for my tastes – I’m much more comfortable with a term of ten years or so.
So what should one do? If you have a definite set-in-stone timeline, you can buy a certificate of deposit that matures before the end of the timeline, then put that cash into savings until the end. However, if you’re unsure about when you’re going to make the move into the Ph.D. program, just stick all the cash in a high-yield savings account and sit on it. It’ll safely return above 5% and you don’t have to worry about it a bit.