Hello there, I’m Myron, your friendly neighborhood financial planner, and today we’re going to dive into a common dilemma: should you stash your money in a high-interest savings account or take a leap into the stock market? With Chocolate Finance currently offering interest rates of 4.5% or more, it’s a question that’s been on many minds lately.
The stock market has always been hailed as the go-to place for higher long-term returns. However, in recent times, it’s been, well, less than stellar, leaving many to wonder, “Why bother?” It’s a valid question. But when you think deeper, it tells me two things about you. Firstly, you might have temporarily lost sight of your financial goals. And secondly, you might not fully grasp how the stock market reacts when interest rates are on the rise.
It’s completely understandable to feel the temptation to hold onto cash, especially when interest rates are so enticing right now. But here’s the twist: understanding these crucial factors can make you rethink the wisdom of hoarding cash. In fact, it could be the very thing that stands between you and your ideal retirement lifestyle.
So, let’s break it down. We’re all aware that cash has its role. It’s your go-to for emergencies or short-term needs, and in that context, it’s a wise choice. But what we’re digging into today goes beyond that. We’re talking about the money that you’re pretty sure you won’t need for at least the next 10 years or more.
Now, while a cash account might appear as a safe haven for your funds over long periods, the reality is quite different. Let me explain why.
Keeping Cash for Retirement
The reason we save money today is so we can spend it in the future, typically during retirement, which could be a decade or more down the road. Take James, for example. He’s 50 and plans to retire at 60. So he’s diligently saving now to create an income stream for his golden years.
Here’s the point: when James retires, he’ll only need to dip into a small portion of his savings in the initial years. The rest of the money he’s stashing now will have to remain invested, working for him, potentially for another 20, 30, or even 40 years from today. So even though James is nearing retirement, he’s still very much a long-term investor. He needs a place to park his cash with two main objectives.
First, James wants to ensure that his money maintains its purchasing power. Saving $1 today only to find it can buy just $50 worth of goods 20 years from now is far from ideal. Second, he wants his money to grow because the more it grows, the less he needs to save to meet his retirement goals.
Now, let’s explore some options for James. What if he simply stashed his cash under his mattress? It’s the ultimate safe place for money, right? But the problem is, if James stashed $100 there, it would still be $100 after one or two years. No loss, but no gain either. Yet, when we look at the past 20 years, James’s $1 would only buy him $57 worth of goods today. That’s not the way to reach his retirement goals.
Now, I know what you’re thinking, “Who keeps cash under the mattress these days?” But consider this: many people have left their money in bank accounts offering lower interest rates than inflation. For the past 15 years, even the best savings account rates have lagged behind rising prices, effectively eroding your money’s purchasing power. Even now, with inflation in Singapore at 4.5% and 5.5%, the best savings accounts are still losing you money.
But here’s the thing: those 15 years have been a bit of an anomaly. Historically, you could expect decent real returns on your cash, and it looks like we might be shifting back in that direction. In the US, inflation has fallen to 3.7%, which means you can now find cash accounts with attractive real returns. The UK might be following suit.
In fact, if we examine global data spanning the last 130 years, over a 20-year period, cash has typically yielded more than inflation. On average, if you’d invested $100 in the most competitive savings account, you’d have $114 after adjusting for inflation. This data suggests that we might be moving back to a time when cash could potentially keep up with inflation. However, averages can be misleading because they hide the variability in results.
In essence, what you need to understand is that, whether you actively invest or not, you’re taking on risk. And strangely enough, doing nothing can often be riskier, especially when it comes to your financial future.
Keeping Cash VS Investing
So, how does this all stack up against stocks? On average, over a 20-year period, $1 invested in the global stock market would grow to $278 after adjusting for inflation. That’s a pretty appealing figure. However, it’s important to consider the variability of these results. In the top 25% of scenarios, you’d be looking at $466 or more, but in the top 5%, your returns could soar above $969. Clearly, investing in stocks offers considerable upside potential.
But what about the downside? Well, the 25th percentile sinks to $17, and in the bottom 5% of scenarios, you’d be left with $82 or less. So, the takeaway is that stock market returns are more variable than cash, and this variability is what we often refer to as risk. In simpler terms, stocks are riskier than cash. Now, let’s examine this from James’s perspective and the goals he’s striving to achieve.
Imagine these as two unknown investment options: Option A represents cash, and Option B represents stocks. In 92% of scenarios, Option B, stocks, beat inflation, while Option A, cash, failed in 37% of cases. When cash did fail, it did so by a much greater degree. Moreover, in most scenarios where stocks failed to beat inflation, cash performed even worse.
Now, consider the potential for capital growth; there’s no real comparison. In this light, it becomes pretty clear that holding cash seems far riskier from James’s perspective than investing in the stock market.
So, the answer is rather straightforward: if James wants the best chance of achieving his financial goals, he should invest his money in a globally diversified stock market index fund and then pretty much forget about it. He shouldn’t obsess over his investment account balance until he’s retired. He’s already set himself up for the best odds of success.
However, there’s a catch. James is not a robot. He checks the value of his account every week, and he’s constantly swayed by short-term stock market fluctuations, which can be detrimental. Remember, over the long term, investing in the stock market is the least risky option and provides the highest chances of success. But in the short term, it can be extremely volatile.
Now, you might be thinking, with high interest rates, shouldn’t it be more challenging for the stock market to outperform cash, especially in the short term? That’s a logical question to ask. But let’s consider the big picture. On average, the global stock market has delivered around a 9% annual return over the long term. This might not seem as appealing now that you can get a guaranteed 5.5% return in a savings account. However, this perspective misses a fundamental concept: the equity risk premium.
Risk of Being an Investor
This premium is the extra return that you expect from stocks compared to what you can get in a risk-free savings account. So, let’s say you could get a 4.5% return on your cash, with inflation at 5.5%. How much of a premium would you demand from stocks to make them worthwhile?
You see if you could get 4.5% in a bank, hardly anyone would bother with the stock market. Stocks are riskier, and they need to offer a premium to lure investors. In a poll I conducted, the majority of respondents agreed that a 13-15% premium above what they could get in the bank would make stocks attractive. Let’s call it 14%.
Interestingly, looking back over the last century, the premium that stocks have offered over cash is around 5%. Historical data suggests that when interest rates are higher at the beginning of a period, stocks tend to deliver higher returns over the following years. So, instead of seeing the stock market as a vehicle for a 9% return on average, it’s more accurate to perceive it as priced to deliver an expected premium over what you can earn on your cash—this is the equity risk premium.
Here’s the key point: that premium may not materialize in the short term, and that’s the risk investors take on. But when there’s a lot of demand for risk, like in 2021 when the stock market was performing well, it pushes up prices and reduces future expected returns. But when the stock market is less enticing, such as now when it’s been disappointing for about 18 months, and you can get a 5% return on your cash, the stock market begins to look more appealing.
So, when people start asking if the stock market is still worth it and whether they should stick to cash, it’s a good indicator. It tells me that the future prospects for the stock market are looking better than before.