Finance 101: Part 4 – Overview of savings vehicles

There are seemingly infinite options available for savings these days.  I probably understand more than many, but definitely only a subset of the cornucopia one can put money to work.

For those looking for an intermediate text on investment vehicles and strategies, I can definitely recommend Expected Returns by Antii Ilmanen.  I’m sticking with the basics here.

Savings vehicles, listed in order of (my perception of) complexity and risk:

1. Government-insured bank deposits.  No real description needed.  If kept below the insurance level, these balances have a place for instant access and emergency funds.  I recommend Money Saving Expert or Bankrate.com for comparing best rates.  Remember – if the bank is government insured (I’m clenching a bit due to the IceSave situation, but we can talk about that another time), the only factor that really matters is the interest you receive.  It’s all the same otherwise!
2. Bank Certificates of Deposit (CDs).  Same as #1, but this time you’re locking up your funds for a certain period of time.  If you need the cash earlier, you’re paying away some accrued interest or even principal.  Some CDs aren’t government-insured, so be aware.  Use the same resources as #1 for the rate comparison.  Choose a time frame which you’re happy to lock away your money.
3. Government bills.  Treasuries for Americans; Gilts for Brits.  They’re as safe as #1 and #2, but less accessible.  Use TreasuryDirect to buy Treasuries from the government (to avoid brokerage charges).  The DMO in the UK has info on buying Gilts; not as easy as Treasuries!
4. Money market funds.  Most probably experience this as the ‘cash sweep’ option on their brokerage accounts.  These are not insured, but invest in high-rated, short-term government and corporate debt.  Biggest additional risk here is credit risk, but generally minimal.  Another problem these days: yield on these funds may be the same or lower than management fees, so you won’t make any interest!
5. Government bonds.  The difference between #3 and this is duration – similar to the difference between #1 and #2.  If you purchase a 10-year Treasury, you’ll need to hold for 10 years to get the full yield; selling on the secondary market means you may lose more than your initial investment.  With interest rates at near-record lows everywhere in the world, I think long-dated bonds are as risky as they’ve ever been.
6. Investment-grade corporate debt.  This takes #5 and adds credit risk.  According to the book referenced above, there is little to be gained purchasing investment-grade debt rather than government debt in the long term.  Beware, those who chase the extra yield of corporate debt; frequently they’re priced correctly.  Utilise brokerage accounts to purchase these; there is no exchange, so you’ll have to buy directly from a dealer.  Which reminds me of the stories of BMW-driving, mansion-owning bond dealers.
7. Utility stocks.  I put this as in-between debt and equity, for personal investing.  Steady cash flows and high regulation mean these guys have high financial leverage, but can sustain that and recurring dividend payments that frequently exceed corporate debt interest.  Keep in mind that, as interest rates move higher, these utilities will use more of their cash flows to pay debt interest rather than dividends.
8. Broad stock indices.  In particular, S&P 500, the Nasdaq, FTSE 100, MSCI World, etc.  This is generally what is meant by pundits when they say ‘buying the market’ or ‘stocks moved higher/lower’.  Purchase low-cost index tracker funds (see Vanguard, for a start) or Exchange Traded Funds (ETFs), with the smallest possible fees, across a range of geographies.  For the majority of savers/investors (I’d wager), this category represents the vast majority of their portfolios.  Or should.
9. Real estate Investment Trusts (REITs).  These are equities, purchased through your broker, which mirror the returns of holding/building/financing real estate.  They generally pay out healthy dividends, but their capital is very much at risk both to interest rates rising and to an economic downturn.  On the plus side, they tend to diversify a little bit from the overall equity market.  I’d recommend purchasing an ETF basket of several REITs, rather than any single name.
10. Individual corporate equity.  Think you’re good at picking stocks?  It’s extremely unlikely you’ll beat the indices in #8.  A big issue is skewness of returns: purchasing equity in a single company means you have a much higher risk of losing big (that company might declare bankruptcy, after all).  This issue isn’t really an issue with #8.  The same goes for actively-managed stock mutual funds: time after time, these funds underperform #8.
11. High-yield corporate debt.  Why more risky/complex than equities, you ask?  How much do you know about recovery rates, and their correlation with the business cycle?  Can you understand senior/subordinated loans and bonds, either with or without security?  The book mentioned above finds no benefit of owning high yield credit above Treasuries, with the exception of ‘fallen angels’ – companies who become high-yield from previously investment-grade.  Anyway, credit spreads are near all-time lows, so methinks this is a tough area to enter.
12. Real estate.  Yes, this includes purchasing your first house.  Folks in London can’t stop talking about real estate prices, and ‘getting on the housing ladder’.  Here’s why I put this type of investment so low on the list:
    1. Lack of diversification:  putting aside calamities which may or may not be insurable: what if your neighbourhood goes to the dogs?  Your house may not be worth anything like what you’ve paid for it.
    2. Leverage, leverage, leverage:  few folks buy their first house in cash; mortgages are essential.  If you have 5% as a down payment, you now have 2000% leverage on a (non-diversified) investment.  Fantastic news if house prices march ever-upwards; horrible news if you purchased in 2007-2008.  See this fun/depressing map from Zillow to see how many people are still underwater on their houses.
    3. Ancillary costs: who knew prepping a house for sale could be so expensive?  Or the realtor fees?  The market is generally illiquid, so hopefully one can get a reasonable price for the house when it’s selling time.  As for buy to let: management fees and capital expenditure can be unknown and expensive.

OK, off my soapbox on the last one.  I will continue the discussion, into alternatives, in the next post.