So what do ordinary consumers do in such an environment? On a recent post I described the miserly interest rates currently available, where short-term certificate of deposits (CDs) have been below 1% for the past four years, far below the usual 4%-10% range that have existed for most of the past 50 years. Given that such investments usually provide a secure, significant return, and now don't, where are savers and investors to turn?
In such a low interest rate environment a common response is to move up the risk scale looking for higher return. Indeed, that is one of the responses desired by government officials who want a higher level of risk-taking going on in the weak economy. Unfortunately, more risk-taking by savers often leads to big losses when those investments go sour. This was evident in the stock market corrections in 2000-2002 and in 2008-2009. Many investors, many of whom considered themselves to be "conservative" savers saw losses of 30%, 40% or more on their savings.
So what are some of the keys for saving in a low interest rate environment?
First, don't speculate in the stock market with conservative savings. Speculating means putting money in stocks and other risky investments without the willingness to hold onto those investments for the long-term, a minimum of 5 years, but preferably 10 or 20. Holding for the long-term and a willingness to not sell despite market downturns of 30%, 40% or 50% differentiates investing from speculating. We saw in the last downturn that many investors and savers, especially those in their 50s and 60s, ended up selling their investments after sharp declines because they did not the ability, time-horizon or willingness to hold on for the long-term.
And what are "conservative savings"? That's simply money that you want to see little or no decline in value and/or money that you may need within the next several years. Such money should generally not be put in the stock market or other risky areas of the financial markets (including bonds, commodities, real estate, commodities, etc.). Since nearly all financial assets have the potential for large declines, short-term or "safe" savings should not be invested in risky financial assets.
Investing in bonds poses a particular risk for conservative investors. One of the primary reasons why many bond investors are investing in bonds is because such investments are considered safe, at least compared to stocks. And generally they are. Whether on a monthly basis or over a multi-year period, bonds as a whole are generally less volatile than the stock market.
But this doesn't mean that bond values don't go down. During times when interest rates rise, the value of most bonds falls. Sometimes these are very steep declines. Lately we saw the value of many municipal bonds, which are generally considered to be some of the safest bonds, fall by 20% or 30% over just a few months in mid-2013.
One problem that may be impacting the perception of many current bond investors is the general decline in interest rates over many years, causing bond prices, and investments returns, to generally rise. But now we are at a point in which interest rates are so low, any increase in interest rates will result in losses, at least temporary ones, to most bond market investors.
There are two components to mutual fund bond market returns for investors. The first is the amount of interest that is paid by that pool of bonds. The second component is the return from an increase or decrease in the value of that bond, and again, the value will usually rise at interest rates fall. So for example, if a pool of bond only pays 3% interest over a year, but falling interest rates causes the value of the bonds to rise another 5%, then that investor will see an 8% return over the year. However, as interest rates continue to decline, the yearly interest paid also does so, and investors are relying more and more on (usually) falling interest rates to earn desired returns. But at a certain point, whether 3%, 2%, 1%, the paid interest will be very low and the potential for falling interest rates (and an increase in value), will also decline. So assuming that interest rates don't continue to fall, investors have to ask themselves if it is worth the risk to buy bonds when the interest paid will only provide 2% or 3% per year and there is the potential for large declines?
Another mistake in the bond market that many investors are making is investing in the higher-yielding areas of the bond market. Perhaps no surprise, over the past few years as interest rates have provided very low levels of interest, many previously "conservative" bond investors have moved up the risk scale to invest in high-yield (also called "junk") bonds. The problem with this strategy is that is precisely these risky, higher-yielding areas of the bond market that have the most potential for volatility and loss. Many investments in these risky areas of the bond market have seen losses of 40%, 50% or more, even during times of relatively stable interest rates.
So to sum up: don't let low interest rates, and the resulting low returns that safe investments such as savings bonds or CDs provide, pull you into the stock market or other risky areas of the financial marketplace, including risky areas of the bond market. As a rule of thumb, you should not put any money into these risky areas of the financial markets (hopefully, as part of a diversified investment portfolio), unless you are willing to ride out any severe market declines, and are willing to leave that money alone for at least 5 years, but preferably 10 or 20 years.
Money that is more short-term in nature, such as those used for living expenses, or for short-term goals like saving for a house, vacation or car, should be invested more conservatively, despite the low interest rates.
It is an unfortunate fact that the Federal Reserve's efforts to keep interest rates so low will simply provide a low return for savers. Indeed, many savers in savings and checking accounts are receiving any return on their money, let alone a satisfactory one. I believe that generally, the sensible strategy is to invest in riskier areas of the financial marketplace with money that you intend to leave alone for 10 years or more, yet keep money that you need for shorter-term expenses on hand, in low-risk investments, despite the miserly returns that you'll earn.
Even in a low-interest rate world they are places where you can earn a safe return on your money. Bankrate.com, as well as other online financial product screening websites, can show which financial institutions offer better interest rates on your safe money. Some financial institutions offer special deals, such as on CDs, in the hopes of securing you as a long-term customer. Even with these strategies you are unlikely to earn a high return, but a safe, low return is often preferable to a hoped-for higher return in a risky investment. One investment maxim often heard (often after sharp market declines) is that investors are not so much looking for the return on their money, but for the return of their money. When the time comes that you want the return of your money you want to be sure that it'll be there.