Conservative investments, such as bank savings accounts or CDs (certificates of deposit in a bank), may not be as safe as you think. These types of accounts may actually produce negative real return rates over the years.
Three main factors are responsible for negative return rates:
- Low interest rates
Low interest rates
Years ago, interest rates on bank savings accounts or CDs rates ranged from 3% – 6%. These days, interest rates are close to zero, generating almost no revenue.
Low interest rates create a specific problem for retirees because when they originally invested their money, they expected to make a higher return rate than what they receive now. As a result, their savings may not have as much purchasing power as previously.
Inflation erodes the value of your money while it sits in the bank. For example, what would happen if an investor put $100 into a bank savings account earning nearly no interest? That year, $100 is enough money to buy a leather jacket. But what if, when he retrieves the money the following year, inflation raised the jacket’s price to $105? In that case, the initial $100 is no longer enough to buy the jacket, so the $100 is worth less than the previous year. This change in money’s value is called “inflation.”
Paying taxes is an ongoing expense, which lowers your net return. When interest rates are low, and inflation reduces the value of your money, taxes top it all off, resulting in negative return rates, even in so-called “safe investments.”
How to profit with bond ladders when interest rates are low
A bond is a loan that an individual makes to a company or government. Each bond has a set time period and interest rate. Usually, the longer the term of the bond, the higher the interest rate will be. At the end of this loan, the individual gets the original sum back.
Bond ladders are a great tool to help diversify fixed-income investments (i.e., investments which have a predictable return rate and schedule). Bond ladders are a fixed-income investment, but instead of investing the entire sum of money at once, they allow an individual to distribute his money over the course of time. For example, if you want to invest $100,000 in bonds, instead of investing it all in a one-year bond, you could divide the sum into four parts of $25,000 apiece, and buy four different length (read: different levels of interest rate) bonds. The first $25,000 will mature after one year, the second $25,000 will mature after two years, the third $25,000 after the third year, and so on.
When interest rates are low, bond ladders can be a useful tool since they allow you to take money from low interest rate investments and put it into longer-term (higher-rate) bonds at the end of the ladder.
Everyone has a different risk tolerance level, and therefore, an investment appropriate for one person isn’t necessarily what’s best for another. Before buying bond ladders, consider what type of investment is best for you.
To learn more about bond ladders, read this article.
Douglas Goldstein, co-author of Rich As A King: How the Wisdom of Chess Can Make You a Grandmaster of Investing, is an avid chess fan, international investment advisor and Certified Financial PlannerTM.