I recently wrote an article where I explained two basic financial tips that had helped me stay on track with my finances. It was pretty basic advice, but the email I got from readers was dominated by questions and remarks about my decision to use a 6% interest rate to calculate the potential return on monthly savings of $200. Just how, many people asked, do you propose I get a 6% return? The question underlies a fundamental misunderstanding about a key concept in finance — average returns. If you’re struggling to find a way to earn some interest in this ultra-low interest rate environment, read on to learn why 6% isn’t an unreasonable expectation, even now. (See also: 7 Banks Still Offering Great Interest Rates)
Right now, savers are lucky if they can find a savings account that yields more than a 1% return. That’s because the interest rate you receive in a savings account is determined by the rates set by the U.S. Federal Reserve. Right now, the benchmark interest rate (which represents the lowest interest rate that investors will accept on non-Treasury securities) is currently at a historic low of .25%. However, between 1971 and 2010, interest rates averaged 6.45%. In fact, in the 1980s, those who bought certificates of deposit got rates as high as 14%!
While we’re unlikely to see returns like those any time soon, rates fluctuate over time based on a number of factors. And, because the benchmark rate can’t fall much lower, it’s going to have to head back up at some point. So even if returns are pretty paltry in most low-risk investments right now, this doesn’t mean your average rate over time will be anywhere near as low as the returns you're getting right now. However, your odds are even better if you invest that money rather than save it.
If you understand how averaging works, you can see how your return over many years may be much different from the rate you are currently getting on your savings. However, while a savings account is a must in case short-term financial needs arise, larger amounts of cash should be invested. If you’re looking to maximize returns, a savings account isn’t the best place to park any funds you don’t need to withdraw in the near future. If you’re looking to earn more on your money, consider an index fund, mutual fund, or even a well-tended stock portfolio. You could lose money in these types of investments, so if you're not a pro, you should use them sparingly and consult a financial advisor. However, it's risk that dictates your potential for return; adding just a little to your portfolio can drastically increase your chances of a better return. And, just as in saving, time is a big factor. For example, if you stick that money in an S&P 500 index fund, you have a 55% chance of earning 10% in one year. Keep the money in for 10 years, and your odds are closer to 85%.
The key for investors and savers is not to worry so much about what the rate is right now, but to set up a habit of saving consistently and keeping that money invested. If people save and invest consistently over time, they will be able to maximize returns and minimize risk. So, just as past performance doesn’t indicate future returns, current returns don’t dictate your average return over time. When it comes to money, time is one of the most important factors; returns may be poor right now, but if you stay the course, you are likely to get a chance to make up for those low returns down the road.
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