In search of higher returns

Stocks may look tempting in the face of dismally low interest rates on savings -- but look before you leap.

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By Walter Updegrave, Money Magazine senior editor

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005)

NEW YORK (Money) -- Question: I'm 58 and have $30,000 sitting in an online savings account earning around 2% annually. Is there some way I can get a better return on this money? I want to use some of it within the next five years or so for travel. --Nate, Texas

Answer: When I was a kid and asked my mother for something she felt we couldn't afford, she'd look at me and say, "People in hell want ice water."

What does my mom's response -- which, by the way, ended the discussion, pronto -- have to do with your question?

Well, I'm sure that most people with money sitting in short-term CDs, savings accounts and the like earning 2% or less would like to get a higher return on their money. I'm not exactly thrilled with the 0.10% yield on my U.S. Treasury money-market fund. Whoopee! $10 a year on a $10,000 investment!

But just because we want something doesn't mean we can have it. The reality is that short-term interest rates are scraping along the floor these days. So if you want the security of principal offered by FDIC-insured bank accounts and other short-term income investments, you've got to accept the paltry yields they're paying. Those low yields are the price of sheltering your money from the ups and downs of the financial markets.

Saving vs. investing

That's not to say you can't shoot for a higher return elsewhere. Stock mutual funds, for example, have been looking quite alluring recently, what with the Standard & Poor's 500 index up about 16% on a total return basis since the beginning of the year.

But if you move your stash into stock funds you'll be taking more risk. To see what that could mean in your case, let's do a little thought experiment.

Suppose that back in October of 2007, when everyone was still quite enchanted with the stock market, you were planning to take a nice trip to tropical climates sometime in the winter of 2009. And let's assume that since you were dissatisfied with the returns your $30,000 travel fund was earning in a savings account, you decided to do something more adventurous with your stash, like move it into a broadly diversified stock mutual fund.

How would you have fared?

Not so well. By the beginning of January of 2009 your $30,000 would have declined in value by almost 40%. So instead of having $30,000, you'd have a bit more than $18,000. At that point, maybe you'd figure that it would make sense to postpone your trip a few months to give the market a chance to recover and recoup your losses. But by the end of February, you would have had even less, just under $15,000. If you'd held on even longer, you would have participated in the recent market rally. But even if you were still holding out as of last week, you would still have only $21,150, or about 30% less than your original $30,000.

You also incur the risk of falling short of what you need, by the way, if you seek a higher return by moving to higher-yielding longer-term bond funds. That move could pay off if interest rates stay the same or drop (in which case the longer-term bonds would generate capital gains, boosting your return beyond the bonds' yields). But if interest rates rise, the price of the bonds would fall, which could eat into your yield, or, for that matter, even wipe it out entirely and hand you a loss, which was the case for many bond funds last year.

The point is that if you think you're going to need your money within a few years, you can't put it in volatile investments that may be down when you're ready to pull your money out. Stocks and bonds are fine when you're investing over longer periods and have time to bounce back from setbacks. But when you know you'll want access to your money relatively soon and you want to be absolutely positively sure it will be there when you need it, you've got to limit yourself to savings accounts or other secure options, even if doing so means having to settle for a puny return.

This is true whether you're going to need the money for travel, a house down payment, college tuition or to cover emergencies. It's also the case for the money a retiree will need over the next one to two years to cover living expenses.

Now, you may be able to squeeze out a slightly higher return if you've got a bit of wiggle room -- say, you're thinking of taking your trip in two years, but could easily put it off for a couple of years or you need to pull out only a small piece of your $30,000 for travel.

In that case, you might be able to put a portion of your savings into a short-term bond fund that offers a higher yield than your savings account and that shouldn't get hammered too badly should rates rise. And if you really think you won't touch the money for five years, you could even put a small portion of it into stocks (although you would want to be all in cash within two or so years of when you think you'll need the dough).

But remember: higher gains don't come free. Once you venture beyond cash equivalents like short-term CDs, savings accounts and money-market funds, you run at least some risk that your account value may be down just when you need the money. And the more you stretch for extra return, the more hellish the consequences can be if the markets don't move in your favor. To top of page

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