Retirement Answers

Jacob: 00:02

The more that you touch your account, the smaller it's gonna get. And that includes taking money out of your account for spending or just living expenses, but also the more you touch your account in the way of picking stocks or trying to time the market or getting out of your long term positions to buy CDs or money markets because they're providing a short term 5% interest rate. Just in general, the more that you transact in your accounts, the smaller they'll get. Welcome to Retirement Answers, a podcast built to answer your most pressing retirement questions. If you're someone who's either thinking about retirement or already in retirement, well, you're in the right place.

Jacob: 00:37

Hey there, my name is Jacob Duke, each week I'll be walking through different tips and strategies to help you succeed in retirement. So let's go ahead and get started with today's show. Hey everybody, and welcome back to Retirement Answers. I hope you are having a great week and a great summer. And today I wanted to talk about cash.

Jacob: 00:57

I wanted to talk about interest rates, money markets, and CDs, because over the last year, the Fed has increased rates so quickly. And as a result, mortgage rates and car loan rates have increased too. So as these rates have increased money market and CD rates have increased as well. And in fact, right now you can get a six month CD for 5.35% APY. And this is a very welcome sight after many years of tiny yields on cash and money markets.

Jacob: 01:24

And finally, our cash is earning some interest. But while most of us are rejoicing over these higher interest rates, I'm a little bit concerned. Not because I don't think that higher interest rates on cash are helpful or exciting, but because I'm already seeing the bad behavior that these increased rates are causing. People are trading their long term investments, their stocks, their real estate holdings for these guaranteed returns in CDs and money market. And a lot of people are asking, well, why would I risk losing money in the stock market whenever I can get a guaranteed 5% on my cash?

Jacob: 01:56

And that's the question that people are asking themselves and it's a valid question. But for the informed investor, they know that everything is relative. If you're getting a good rate on your cash, that means that debt is likely more expensive. And if rates are increasing or are elevated, that means that inflation is also likely high. So if we look back at the seventies and the eighties, and we see that the average rate of return on a CD in the eighties was about 12%.

Jacob: 02:21

Wow, don't you wish we could have those rates today? Well, not so fast because inflation back then, as many of you remember, was as high as 14% in 1980 and it slowly declined over the decade. And in addition to that, the thirty year fixed mortgage rates touched upwards of 18% in 1981 and came back down to hover around 10% for the rest of that decade. So is that 12% CD really what you want after all? If cash is a valuable asset in terms of the yields that you're receiving, the environment around you likely isn't a fun one.

Jacob: 02:54

So debt can be expensive, inflation is high, and you could be in a recession as well as you saw there in the eighties. What I'm talking about here is the difference between a nominal and a real return. See, nominal returns are what your CDs or your money markets are paying you. So let's just use 5% yields on a CD in 2023. That's your nominal return.

Jacob: 03:14

That feels really good because that's a lot higher than what we've been getting over the last few years. But what is your real return? Like what are you actually gaining out of that 5%? A real return is what you get to keep after taxes and inflation. So if you're getting a 5% return on a CD, but inflation is 4%, which in May 2023, that's what the inflation report reflected over the last twelve months, inflation was 4%.

Jacob: 03:38

If you're getting a 5% return on a CD and your inflation rate is 4%, well, you're really only earning a 1% real return. And that doesn't even include taking out taxes that you're gonna owe on that 5% yield. So this 1% or less, that's your real return. That's really what you're getting after inflation. And if we go back to the 1980s and we can look at this 10% on a CD, but inflation was also 10%.

Jacob: 04:02

Well, you have a 0% real return. So it feels really good because you're getting a 10% return or you think you are, but the cost of that is inflation is also 10%. Therefore, you're netting a 0% real return. The frustrating part for me as a financial planner is that most people only pay attention to nominal yields, what they think they're getting on their cash. Now don't get me wrong, we will absolutely take these higher yields on cash, but please don't be fooled.

Jacob: 04:28

You're not somehow beating the system or winning the game. If you feel like you're winning, well, you might be anchoring to those nominal returns and those are not real returns. I see this a lot. People are are really excited about that 5% CD or that five and a half percent CD or what they're getting on their money market. What they don't understand is is that they're actually not getting the full return because that's only the nominal return and not the real return.

Jacob: 04:51

So thinking that we're winning with our cash can be problematic, but the bigger mistake that I see many people making is they're exiting their long term investments like stocks to purchase CDs and money markets. They're tired of the volatility and they're conflating volatility as risk, thus leading them to take risk off the table by investing in those fixed income assets. And most people do this just to make themselves feel better from an emotional standpoint, but this could be detrimental to your wealth and growth overall over the long term. So here's why. Once you get conditioned to feel good about getting a 5% guaranteed interest rate on your money, it becomes that much more difficult to get back into the quote riskier investments like stocks.

Jacob: 05:32

You you might be asking, why would I want to get back into volatility when I can sit here and never lose money? And I say that in quotes. Once again, the real returns that you're getting are not as high as you might think, and you're abandoning your long term growth potential. If you decide to exit those long term assets and investments like stocks, mutual funds, ETFs, real estate, if you decide to abandon that and go buy CDs and money markets with that money, when do you get back into equities? And the thing that most of us think is that, whenever the market goes down or a recession happens, that's whenever we're gonna go buy back in and get back into the stock market.

Jacob: 06:06

But the reality is very few people have the stomach to do that. Very few people can actually go and take their money, invest it into something that just went down 30% in value because at that moment, we're watching the news and all it is is red. We're seeing all the negative headlines and the human nature says we can't let ourselves go buy something that has gone bad. And so as humans, it just doesn't make sense emotionally. We can't do that.

Jacob: 06:29

And in explaining this, what I'm really talking about here is the behavior gap. The behavior gap is the difference between what the stock market provides each year on average and what investors actually get. Data shows that this behavior gap is around 3%, meaning that if the market went up 10%, investors are only getting around 7% on average. So why is this? It's because we can't behave correctly when it comes to our money and how we invest.

Jacob: 06:53

Investors make ill timed decisions on when to buy a certain stock or when to sell or when to get out or when to get in. All of these decisions lead to the average investor underperforming the stock market over time. And I have a rule that is for myself, but I also preach this to my clients and it just goes like this. The more that you touch your account, the smaller it's gonna get. And that includes taking money out of your account for spending or just living expenses, but also the more you touch your account in the way of picking stocks or trying to time the market or getting out of your long term positions to buy CDs or money markets, because they're providing a short term 5% interest rate.

Jacob: 07:26

Just in general, the more that you transact in your accounts, the smaller they'll get. So remember that if you're trying to evaluate, hey, should I get out of my stock positions in order to go buy these quote guaranteed 5% interest rates? Well, just know that the more that you touch your account, the smaller it is gonna get over time. So you might be asking, well, Jacob, do I just need to sit there and let everything just happen and go? Yeah.

Jacob: 07:47

That's kind of what I'm telling you to do. In fact, I think that you're just gonna end up with more money one day if you just let it go instead of trying to figure out what to invest in next or when to get out before the market goes down. If you've listened to me for any period of time or have sat down with me or heard me talk about this, you know that I believe that time in the market is far more important than timing the market. So by messing around with your account and trying to chase returns or yields for a short period of time, you're gonna lose out on all of those gains because you're delaying the amount of time that you're actually invested in the market. And if we know anything about compounding returns, we know that the majority of your interest or your capital gains is gonna be earned in the later years of that timeframe.

Jacob: 08:28

So early on, feels like, man, I'm not making much money. I'm not making much progress. The the account is not going up in value as much as I had hoped. But if you keep pressing forward, keep saving, keep doing the things that you know to be right in terms of principle and your disciplines, whenever you get to those final five years of your investment horizon, that's whenever your returns are actually earned. So back to CDs and money markets.

Jacob: 08:50

We feel good right now, but when you look back in a couple of years and yields are three and a half percent and the stock market is up 20%, and you can't figure out when to get back in the stock market, you may not be feeling so good. So for example, CDs are paying 5% right now, but the S and P five hundred is up over 15% year to date here in 2023. Now this is subject to change and at any point the market can give all those gains back, but this is a really short period of time, but it helps prove the point. Stocks are the way to grow your wealth and cash is the way to preserve it. And some of you might be thinking, well, I need to have cash to meet my short term needs or goals in retirement, or I'm trying to take a little bit of risk off the table as I enter retirement.

Jacob: 09:28

And I completely agree with you. Cash has a place in almost every retirees portfolio. In fact, I use a three bucket retirement income plan for all my clients. That's how we kind of plan things out and say, much income do we need to pull and where we pull it from? And this is where I encourage my clients to maintain two years worth of living expenses in cash.

Jacob: 09:45

Now that cash doesn't have to be in the bank, that would be preferred. But just in general, the investment itself needs to be in cash or money market. We want two years worth of living expenses in cash. The purpose of that is to eliminate the risks of short term market declines so that you don't have to sell your investments at a loss. But what I'm discouraging is taking some of your long term investments and purchasing CDs or money markets to try and get a quote free 5% on your money.

Jacob: 10:12

The time lost and the opportunity to buy those stocks at a lower price right now will prove to be a mistake for your long term investments. So I think that the most important thing is developing a thoughtful investment plan and income plan and sticking to it. Avoid chasing those returns of the stock market or even on the cash side of things because long term, it could derail you from achieving your goals. Make sure you have a plan for your income in retirement, and then from that income plan, can develop your investment strategy. So trust your strategy, trust your planning, and know that at any given point, things are gonna look positive or they're gonna look negative, but you shouldn't abandon your long term plan for the sake of a quick short term return that's quote guaranteed.

Jacob: 10:52

Because throughout that time of having a guaranteed 5% return on a CD, you're losing out on the opportunity to buy more stocks at a lower price or stay invested and miss out on perhaps a 15% returns like we're having so far this year in the S and P 500. So I think the biggest issue with these CDs, and I say that they're not a good investment, is because they're really not an investment. They're a capital preservation mechanism. And over the long term, you'll continue to see that the riskier investments, and I say risky in quotes, stocks, real estate, ETFs, and mutual funds, those types of things are going to provide the better returns. Really what it comes down to is your risk appetite, but even more so, I think it comes down to what is your risk need?

Jacob: 11:34

Like what can you do and what should you do? In some sense, our behavior is the thing that determines whether or not we're gonna be wealthy or even stay wealthy. So your behavior within your investment accounts is maybe one of the most important things. I encourage you not to abandon your long term strategies in order to go buy a fixed income return that otherwise could go away at any point. And whenever that does go away and the stock market is 50% higher, well, you lost out on all that just to make yourself feel better about getting a 5% return for a little bit of time.

Jacob: 12:05

So today I feel like I kind of preached at you a little bit, but I just want you to hear these things and understand that cash is not an investment. It's not a long term strategy to make money. At most, it's something that helps preserve money. But remember, we have to factor in the nominal versus the real return. If real returns are not worth having, then you shouldn't have cash.

Jacob: 12:25

Like it serves a purpose from an income standpoint if you have immediate and short term income needs, but beyond that, cash should not be a major percentage of your overall allocation. So consider these different ideas and thoughts as you continue to implement or create your retirement plan. Thank you so much for tuning into this week's episode of Retirement Answers. I hope you have a great week and we'll see you here again next week. Hey, it's Jacob again, and I wanted to extend a quick offer to you.

Jacob: 12:51

If you have a question and you would like to have it answered here on the show, please email me at jacob.duke@appliedcapital.com, and I'd love to answer that question for you right here on the show. Also, I wanted to remind you that nothing discussed in today's episode is meant to be financial, legal, or tax advice. Retirement Answers is for educational purposes only. Thanks for tuning in to this week's episode of Retirement Answers. I look forward to talking with you again next week.