As you probably already know, returns on fixed rate investments are pretty bleak. The Federal Reserve, for the past four years, has effectively set rates to zero, an astonishingly low number. This has made traditionally safe investments (CDs, government bonds, and money market accounts, etc.) limited with their returns for investors. At the time of this writing, the only previously mentioned investments you can find higher than 4% is a 30-year treasury, and I’m not sure that’s a wise bet.
As of right now, Fed rates are expected to stay this low until 2015. I’ll even go out on a limb and state these traditionally safe investments, with their current rate of returns, are not as safe as they may seem. Rates are artificially low, and can only go higher from here. The serious impact of this is that in the long run, any of these investments run the risk of not keeping up with inflation. Inflation risk is a real issue that’s rarely discussed, yet its ramifications are huge. Inflation for the previous 30 years has averaged 3.28%, and there is a good chance it will be higher for the next 30 years. The Federal Reserve is punishing savers/investors to help debtors, but that’s a topic for another discussion.
So what’s the 4% rule?
I consider this a key aspect of my security bucket of investments. These are investments that have a low beta, but still generate monthly income. I have this rule because of the tax man; inflation and expenses quickly eat at your return leaving you with nothing, but you can make your return effectively zero. If expected returns are lower than this, in my opinion, you are better off not investing in that particular asset. If you have a 5+ year investment horizon, you should get much more sizable returns on your investment, which will help you build wealth. Any investment goal of less than 5 years should be only put into fixed rate investments, even if it is less than 4%. The goal is to prevent having to take the money out of the investment at an inopportune time. Money invested should be used for the ultimate goal to increase cash flow and should not be needed for any short-term goal. Think of investing as a tool to build long-term wealth. My investment horizon is always 10 – 20 years — something I’ll discuss in future blog posts.
One of the basic rules of investing: The higher return, generally the higher the risk. Depending upon the investment, there are things you can do to mitigate risk, but the general rule applies. For the past 100 years the return of US stocks has averaged 8%. With your investment, you may do better or worse, but it is your top line goal. Annual investment returns above 8%, while possible, have the odds stacked against you. Getting somewhat safe returns of above 4% isn’t difficult and should be a realistic goal you should shoot for.
The government is forcing investors, on purpose, to put their money into riskier assets. The question becomes, what other investment options are available that offer higher returns, yet are not as risky as, say, stocks? Since traditional fixed rate investments are earning nothing, what other alternative investments are available?
- Peer-to-Peer Investing: See Lending Club and Prosper
- Ginnie Mae bonds
- Master Limited Partnerships (MLP)
- High interest savings
- TIPS and I-Bonds
- Corporate and junk bonds
- Muni bonds
- High dividend stocks (dividend aristocrats)
- REIT Investing
- Whole life insurance
- Debts owed
Each can and will be a future blog post discussing each in detail. Like the song, “Which one of these is not like the others?”, it’s the last one, of course. Any debts you may have are not traditionally thought of as “investments”. Benjamin Graham mentions in “The Intelligent Investor”, like a scale, investments are always compared to other possible investments. Although debt owed is not discussed, I believe it should also count as paying down debt is a guaranteed return on investment. For example, if you have a credit card rate that is 8% or greater, you should pay off that debt first before adding additional investments to your portfolio. It’s a guaranteed rate of return that’s hard to beat. It becomes much harder to find investments that can consistently beat 6-8% year after year. If you find something that will, go for it, but the odds are stacked against you. Home mortgages, because of their tax deduction, can have a higher APY (8-10%) before pre-paying. Bankrate.com has a great calculator for your mortgage interest rate after taxes and use that as a guide for the number to beat.
The questions you have to ask with any investment:
- Can I get a better return somewhere else?
- Does that investment have a similar or less volatility?
As the Federal rate increases so will the traditional investments in: CDs, government bonds, and money market accounts. Once their returns go above the 4% annual rate I will consider them attractive investments again. For now, I am placing money from my security bucket into alternative investments.
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