I was recently speaking with a young woman who has a goal to purchase a home in 15 years. She received advice from her friends to place savings for that goal into a high-yield savings account. She’s not the only young person I’ve seen to consider ultra conservative investments for long-term goals.
In the past couple years, I have seen many young people turn to CDs, high yield savings accounts, money market accounts, short-term treasuries, and other very conservative investments for a wide range of far-off goals. While all these investments could be preferable to stuffing dollars under your mattress, they may not be the most efficient vehicles for long-term goals. Let’s discuss ultra conservative investments, why people are in them, where they’re useful, and where other types of investments may serve you better.
Why People Are In Ultra Conservative Investments
Here are some reasons investors choose to keep more than three to six months of emergency reserves in cash and cash alternatives:
- They have a near-term cash need.
- They are afraid of the stock market.
- They don’t understand the basics of investing.
- They are attempting to time the stock market.
- They are not sure what their financial goals are.
From an investment and returns standpoint, reasons two through five are not good reasons to be in ultra conservative investments. Only a near-term cash need would be a valid reason from a purely logical perspective.
When Ultra Conservative Investments Are Effective
If you’re buying a house, buying a car, funding a wedding, paying for college, or have any other large lump sum need in the next zero to three years, then ultra conservative investments like high yield savings, CDs, money market accounts, and short-term treasuries may make a lot of sense. You’d have liquidity by the specified date of your choosing and receive modest returns.
These types of investments are also effective in an emergency fund for the same reasons. If you do not have a near-term cash need and you are holding greater than six months of expenses in emergency reserves, it may be time to investigate other strategies.
When Ultra Conservative Investments Are Not Effective
If you are saving for an intermediate to long-term goal (you have more than three years), ultra conservative investments tend not to be as effective as other traditional investments.
If you invested $1 in U.S. Treasury Bills (short-term debt backed by the US Government) in 1926, you would have $22 today. When you see that, you might think, “hey, 22 times my money isn’t so bad over almost 100 years.” That is true, until you compare those returns with the stock market.
Stocks are ownership stakes in companies. In this discussion, I’m assuming investors are not picking individual stocks, but investing in diversified bundles of stocks, known as funds. If you invested $1 in a large company index in 1926, you’d have $11,527 today and you’d have about 2.5 times that number if you invested in a small company index.
True, not everyone has nearly a 100-year time horizon. So, let’s look at shorter periods. If you look at 30-year periods in the S&P 500, the average annualized return has never been lower than 7.8%.
There were some10-year periods where people were better off with cash than the S&P 500, like the Lost Decade which started toward the top of the Dot.Com Bubble on December 31, 1999 and ended toward the bottom of the Housing Crisis December 31, 2009. But you shouldn’t just be investing in the S&P 500 when you’re investing. A small company index returned 74.4% during that same period. Investors who have some time and broadly diversified stock portfolios could end up with many more assets than their conservative counterparts.
Bonds are considered conservative investments but even they have a lot more fire power to get people to their investment goals than the ultra-conservative investments we’ve discussed. At their core, bonds are debt instruments. You are lending an organization money over a specified period and in return, you are paid interest until the money you lent is paid back in full. Many bond investors also choose to diversify these debt interests by investing in funds that hold and manage many bonds. A 100% bond investor would have had an average rate of return of 6.3% from 1926 to 2021.
While bond funds can come with several risks, including interest rate, reinvestment, default, and inflation risk, they can be effective at creating income without investors needing to dip into their original investment. For this reason, many retirees have a significant portion of their retirement assets in bonds.
Conclusion
While cash, cash alternatives, and other very conservative investments have their place in your financial plan, you should think critically about your financial goals before allocating more than your short-term cash needs to these types of investments. Investing involves risk, but with a diversified portfolio, greater risks are usually rewarded with greater returns. Consider speaking with a qualified financial professional about your goals and risk tolerance to see which other types of investments may be appropriate for you.