Over the last few days, with all the tumult on Wall Street (AIG and Merrill and Lehman, oh my!), several people have written to me expressing deep personal concern about investing in the stock market. They see a 25% dip in the value of the market this year and hear a lot of apocalyptic talk and they’re rightfully concerned about investing in the stock market.
Lucas put it best:
After paying off all my debt, I had planned on following in your footsteps and open an account at Vanguard and invest some of my extra money there, but the stock market really scares me and with banks failing I don’t feel safe putting my money there. What else should I be doing with it?
First of all, the down market doesn’t concern me all that much. In fact, on Monday at the end of the day (after that 500 point loss in the Dow Jones Industrial Average), I maxed out my Roth IRA contributions for the year. My belief is that you can’t actually predict where the stock market will bottom out, but it’s pretty clearly much lower than it was at the start of the year – I’m essentially getting the same index fund I would have bought back in January at a 25% discount.
That doesn’t change the fact that many people simply don’t have that kind of risk tolerance, and if you’re in that boat, your investments should be as conservative as possible – a mix of cash (in savings accounts) and treasury securities.
Treasury securities? I discussed treasury securities in the past, but here’s a summary for those who want a quick refresher. Treasury securities are investments that are backed by the federal government. In essence, a treasury security is a small portion of the national debt – the government issues them so that they can have cash on hand to pay the bills with the intent of repaying that debt (to you) at a later date. If you’ve ever watched CNBC or read Money Magazine and heard mention of treasury notes, treasury bills, treasury bonds, or TIPS, those are all different flavors of treasury securities – here’s more detail about each one. You can also buy good old fashioned savings bonds if you prefer – Series I bonds are matched to inflation.
What are the advantages? First of all, treasury securities (at least those that have a lifespan of a year or more) usually have a fixed rate of return (known as the coupon rate). Let’s say you buy a treasury note with a face value of $10,000 and a coupon rate of 4.5%. Every year, you’ll receive $450 in payments from the federal government (they issue payments every six months, so you’ll receive a payment of $225 every six months). When the note expires, you get $10,000. Treasury securities are a great way to lock in a decent rate on your investment.
One interesting facet of this is that you don’t always necessarily pay a fixed price for the investment – they’re auctioned off by the federal government (don’t worry – this is easy for you to do), so sometimes you might be able to buy a $10,000 investment for $9,800 and other times it might be $10,200 – either way, you’ll get $10,000 at the end. For example, a recent auction on ten year treasury notes (issued on September 15, 2008 and maturing on August 15, 2018) had a interest rate of 4%, but those treasury notes sold for $103.07 per $100 of face value. That means the note itself will actually only yield 3.628% per year.
But there’s an even better benefit – earnings treasury securities are exempt from state and local taxes. In Iowa where I live, that’s actually fairly substantial, as the higher state tax brackets are at 8% and 9%, respectively. Thus, compared to just keeping the money in a CD or a savings account, I get to keep a larger portion of the return on treasury securities.
It’s also worth nothing that treasury securities are very flexible. They’re available at pretty much any price you want (in increments of $100) and have vastly different time constraints, from 28 days (treasury bills, which have a lifetime shorter than a year, don’t issue coupon payments – instead, they just sell for a few percent less than their face value) to 30 years (obviously, the longer term ones pay better). Once you’ve bought one, though, the coupon rate (for longer-term notes and bills) is locked in and the value is backed by the government, so you just sit and collect the proceeds.
Also, one investment option available to you if you invest in treasury securities are TIPS – treasury inflation-protected securities. When you buy one of these, you get a very low “coupon rate” (usually 1-2%), but the value of the treasury is adjusted upwards at the rate of inflation. So, for example, let’s say you bought a $10,000 TIPS for two years with a 2% coupon rate, and each year inflation was marked at 6%. Your first year, you’d get $200 in interest payments, then the security would adjust up to be worth $10,600. The second year, you’d get $212 in payments, then the security would adjust up to $11,236, which is what you’d get back at the end of the second year. So, your total return on that $10,000 investment would be $1,648 – just below an 8% return. Obviously, this investment is based on what inflation does – if inflation is very low (or if there’s deflation happening), it’s a pretty awful investment.
What are the disadvantages? Compared to other investments, your rate of return is usually pretty low. It usually varies between 2 and 6% in returns, depending on a huge number of factors. Before diving in, you should make sure that you won’t get a better return just keeping your money in a high-yield savings account (remembering, of course, that such accounts do cause you to pay state and local taxes on the interest, while treasury securities do not).
In short, if you’re a very conservative investor who wants to stay out of the stock market, treasuries are a great (and simple) way to go. The best part is, as an individual investor, the federal government makes it very easy to get started.
The signup process is pretty painless, taking only about five minutes or so. The biggest annoyance is that you have to wait for the government to mail you an “access card,” which basically is their method of verifying your mailing address so that they can be sure who you are.
Once you’re in, you link your checking (or savings) account to your TreasuryDirect account. You then pull in the money you need from your bank (they call this buying a “certificate of indebtedness”, but it basically just means you’re holding some money in your TreasuryDirect account) and start buying. You have to invest a minimum of $100 if you’re buying treasury notes, bills, or bonds, and a minimum of $25 if you’re buying savings bonds. The procedure is pretty straightforward for each of them – place an order, wait for the next auction, then hold those treasuries and have the returns swept into your checking account. This is exactly how one of my friends does it – he has a substantial amount of treasury investments, enough to live off the coupon payments.
So, here’s what you need to know;
Treasury securities are extremely stable investments backed by the federal government. They return a very steady guaranteed rate and you don’t have to pay state or local taxes on the returns, though the rates of return are very low and are often comparable to what you can get in a savings account or a CD. Be sure to compare the rates before you invest in either one. Treasury investments exist for almost any term you’d like, from 28 days to 30 years with lots of increments in between.
If you do decide to go for it, actually investing in treasury securities is quite easy. Just use TreasuryDirect.gov – sign up for an account, link that account to your checking account, and invest away. Since it’s linked to your checking, you can just sweep the proceeds right back into your checking account.