Originally published Nov. 18, 2009 at FiLife.com
Robert Schmansky, CFP(r)
Like the rest of the world, you've watched the diving and stagnant interest rates on your savings and money market cash reserves over the last year with horror.
It wasn't long ago your funds earned ~3% in 2008, and were cruising along in 2007 at 5.5%.
Everything else being equal, we all would love to be earning a safe and steady 5.5% in today's economic climate. But it is because everything else is not equal that your cash returns won’t end up much better, or worse, than the glory years of 2007; or many other years for that matter.
The interest rate isn’t all that is important
Over time, whether cash accounts have earned 1% or 10%, earnings in terms of spending power have been relatively consistent.
Take the high-flying rates of late 70’s and early 80’s as an example. In 1979 the average one-month CD posted rates of 11.5% (Federal Reserve Statistical Release H.15). In real terms (what those dollars could purchase after inflation) investing in that CD would have lost money, because the cost of goods and services outpaced that savings rate.
In fact, over the last several decades where rates have ranged from next-to-nothing to double-digits, real returns on cash have not been nearly as volatile.
Over time, the real returns of holding cash are between 0-2% after inflation (using CPI as a proxy for inflation, 80 years of data on one-month US Treasury bills from Ibbotson Associates, and 40 years of data on one-month CD rates from Federal Reserve Statistical Release H.15).
The purpose of cash reserves are to act as a store of value to be accessed immediately, without monetary loss. And today, with no inflation to speak of currently, low interest rates are to be expected.
So, instead of worrying about a 1% rate, or reminiscing about the good old days of 5% yields, be confident your cash is earning a predictable real rate of return, wherever rates go.
Hindsight Bias & Timing
Part of the dilemma most savers face involves the 'if only'. You may think back to 2008 and recall how you knew -- of course rates will rise again soon!!! --, so you didn't lock in that 4% CD you now know you should have.
This phenomenon is called hindsight bias. While it is more often associated with trying to time the stock market, it also exists in the cash and interest rate market. We look back and 'knew' we had the answer, and kick ourselves for not making a move.
And looking back that may have been a good move, but like the stock market, interest rates aren't as easy to predict as many would expect. I'm positive if the average saver acted on all of their hunches about the future direction of rates, they would end up worse off than taking a hands-off approach. It's that we only remember the times we didn't act when the outcome could have been positive that is the problem.
Just as you didn't know what to do then, there is no reason to think rates will be higher, lower, or the same two, four, or ten years from now.
What You Can Do
One way to supercharge your cash returns may be to consider a branchless bank.
If your bank's rates don't compare with established branchless banks like Schwab Bank, EverBank, ING Direct, and other providers, then consider using one. These banks pay higher rates due to lower operating costs than your neighborhood, brick-and-mortar bank.
Another place to take a second look is your steady, but frequently ignored, credit union. Many have special rates available if you direct deposit, keep a minimum balance, or some other potentially minor caveat. So long as it doesn’t hinder how you handle your finances, consider revisiting your credit union and taking them up on it.