Stock benchmarks include US large cap (S&P 500 Index), All US (CRSP 1–10 Index), and Global (MSCI All Country World Index) for at least 20 years, ending year-end 2022. Assumes dividends are reinvested. Past performance is no indication of future results.

Full Transcript

Why would I put money in the stock market when the interest rate at my bank is 5%?

As interest rates have come up over the past couple of years, the rate that high-yield savings accounts are paying has also drastically increased. Now people are asking, does it make sense to put money in the stock market when the bank savings account is a guaranteed 5%? That’s a great question. Let’s talk through when to put money in cash versus when to invest.

Let’s start with cash. There are three buckets for your cash needs. One is your day-to-day spending. So, this would be like your checking account, and you want to make sure you have enough of a buffer in there to weather the ebbs and flows as transactions go in and out.

Next is going to be your short-term savings. These are any short-term goals that you have, whether it be a new car or an upgrade to your house. Your short-term savings goals are going to be any large expense that you expect to have in the next few months to a few years.

And lastly, is your emergency fund. I recommend that all of my clients maintain an emergency fund of at least 3 to 6 months’ worth of expenses. Now, for the emergency fund and generally, for your short-term savings goals, it usually makes sense to put this in a high-yield savings account. That way, you’re getting more than a few tenths of a percent on your money. Right now, some high-yield savings accounts are paying up to 5% interest. Now, this 5% interest is a much higher rate than it was historically, and let’s talk about how that compares with stocks and a real rate of return.

When it comes to this 5%, first we want to look at what is your after-tax return. If you’re in a higher tax bracket, we’re going to assume that the government takes about a third of your income, and interest is taxed at ordinary income rates. So, if they’re taking a third, your after-tax rate of return will feel more like 3.4%. Now, when looking at your real rate of return, how does that maintain your purchasing power with inflation, right now, inflation has come down to about 3.5%. So, after taxes and after inflation, you’re not actually making any ground. Your real rate of return after taxes is essentially zero.Now, because of this, I fully recommend my clients use this 5% for their cash needs, but it’s not a good long-term investment.

Now, let’s talk about where stocks come into play. We’re looking over the long term, over many decades. Stocks have generally averaged an 8 to 11% rate of return, depending on what specific time period and indices you look at. Now, for the stock market, I tell my clients not to put any money into the stock market that they expect to need in the next five years. This way, they can weather the length of most bear markets. Now, of course, with stocks, they are treated differently when it comes to taxes. Stocks have a much more favorable tax rate than interest or income.

If you have long-term capital gains or qualified dividends, you are taxed at a much lower rate than your ordinary income rate. So,  when we look at the historical performance of stocks, and the favorable tax rate, you’ve got a much higher likelihood of having a higher positive real rate of return after taxes. Now, of course, past performance does not guarantee future results.

If you would like help deciding how much money you should have in cash versus the market, or where to invest that money once you do put it in the market, please reach out to me or another financial advisor.