In following the Choose FI group on Facebook, I feel like it’s almost a daily event for someone to ask some form of this question:
“I want a place to save money and earn interest, but I want less volatility than the stock market. What are my options?”
The overwhelming number of responses recommend so-called “high-yield” savings accounts with online or physical banks. In the heydays of 2019, the best of these accounts paid upwards of 3% interest. In my mind, 3% is downright respectable. Most paid less than that, and thanks to COVID-19 many of those rates have dropped well below 2%.
The ensuing comment threads pit one bank’s interest rate against the other and people end up splitting hairs over tenths of a percentage point.
“I’m getting 1.7% right now.”
“Oh yeah? I’m getting 1.8%. That’s way better.”
Honestly, this debate frustrates me a little. Inflation averages around 2.5% – 3.0%. Debating over 1.7% vs 1.8% is just a debate over how much money you’re losing every month.
I feel like people are failing to consider better options in part because they don’t realize how modern investing works. I also think debating tenths of a percent is a waste of time. I want to look at both those things here.
Let’s start with debating minutia. We’re going to use a flying analogy because, well, I’m a pilot and you’re here anyway.
I used to fly the B-1B Lancer, more commonly known as The Bone.
The Bone is quite possibly the sexiest looking war machine of all time. It looks far too sleek for its hulking 477,000 pound maximum gross weight that includes 48,000 pounds of bombs and 205,000 pounds of internally-stored fuel.
As good stewards of your tax dollars, we always put a great detail of time and effort into planning every part of a mission in this magnificent aircraft. We would plan Time on Target (TOT) down to the second, weapon impact angles down to the degree, and fuel consumption down to the hundreds of pounds. (The Bone is a thirsty baby. 100 pounds is good for about 20 seconds at cruise.) We would spend an entire day putting that plan together before the Aircraft Commander and/or Flight Lead spend 3-4 hours formally briefing the plan for the mission.
Unfortunately, it is a universal truth of war that: “No battle plan ever survives contact with the enemy.” Between weather, Air Traffic Control delays, maintenance issues, and more, our plan usually started changing before we even stepped to the jet. We got very good at re-planning things in the air.
After you’ve been through this cycle enough, you dread the slog of mission planning day because you know everything is going to change, no matter how diligently you plan. We cynically referred to this process as: “Measure with a micrometer, cut with a battle axe.”
This is how I feel when people debate tenths of a percent in a “high-yield” savings account. You’d be better off closing Facebook and taking a fare as an Uber driver or a delivery with Instacart than spending more time dithering over which savings account will earn you more interest.
I’m shocked at how people get so locked in to wanting a savings account because most of us have read The Simple Path to Wealth by JL Collins. He barely even mentions savings accounts, instead advising his own daughter (for whom the book was written) to put most of her money in low-fee whole-market index funds, like Vanguard’s VTSAX. For those who are afraid of volatility, he recommends putting a portion of your savings into a low-fee whole bond market index fund, like Vanguard’s VBTLX.
Having otherwise filled our Treasure Bath to a very comfortable level, my wife and I have recently decided to start building up a house payoff fund. This is another hotly-debated topic in communities like Choose FI:
“Should I make extra payments to principal to pay off my house sooner?”
“No! You can do far better in the stock market!”
“No way. That ties up capital that you could be using in other ways.”
“But if it gives you peace of mind and you don’t mind passing up good money, then there are worse ways to spend your income.”
My wife and I decided: why not do both?
We opened a regular old brokerage account on Vanguard and started pouring money into it. Alert to the height of the market and forecasts of a correction, my wife wisely insisted that we not put everything 100% into stocks. We settled on putting 50% of our money into VTSAX and 50% into VBTLX. Our plan is to keep putting money in here and letting it accrue interest. When the value of our account (minus taxes) equals the balance on our mortgage, we’ll pay it off in one fell swoop.
Throughout 2019, we were thrilled with this account. Our shares of VTSAX were up 20-something percent for the year. We figured we’d be able to pay off our house a lot sooner than expected. Then COVID-19 hit and the market crashed.
Were we ruined? Are we in the depths of despair right now? Are we kicking ourselves for not going with a high-yield savings account instead? Hell no!
When we opened this account, we bought VTSAX at $74.25 and VBTLX at $11.05, respectively, per share. At its worst, VTSAX was down to $54.49 per share…a 26.4% drop. Ouch! However, our shares of VBTLX have been as high as $11.63, a 5.1% gain, and are sitting at $11.43 (still up about 3.4% overall) today.
I actually “rebalanced” this account by selling some of my VBTLX shares when they were up to buy VTSAX shares while they were down. I plan to continue dollar cost averaging my way through this pandemic to keep our portfolio balanced.
Overall, our account is up 0.4% from when we started it last September. That’s not great, but it’s also not bad for a market that has been this low overall. In fact, we’re only about 1% below what the best savings accounts around would have yielded during this time.
The important thing, though, is that the upside of those savings accounts is very limited. Even if someone announced a cure for coronavirus today and the economy skyrocketed, those accounts will never pay much more than 2.5-3%.
Before we go on, let’s take a moment to consider the one major downside of this strategy: capital gains tax. The IRS couldn’t just let us save money and put it to use taking care of our families without taking their cut. If I make money by selling any of the holdings in our house payoff fund, I have to pay taxes on the profits.
Many people pursuing FIRE have taxable incomes low enough that the long-term capital gain tax rate is 0%. Worst case, I’d have to pay 20% of my profits. Right now, with my shares fo VBTLX up 3.4%, a worst-case 20% capital gains tax would reduce my VBTLX profits from 3.4% to about 2.7%. That drop sucks, but 2.7% is still a lot better than high-yield savings accounts are doing right now.
With that in mind, let’s note that VTSAX is all the way back up to $71.17 per share today (May 12, 2020.) I have full confidence that a combination of ingenuity and greed will keep the stock market climbing, and that my shares of VTSAX will end up far exceeding the value they had when I bought them. A 3% return is laughable compared to what the overall stock market will do in the future.
Let’s look at the real kicker though. Most savings account holders choose that vehicle because they’re worried about market volatility. What if I need the money on a day when the market is down 20%? I’m screwed, right?
That’s the beauty of having a portfolio balanced between stocks and bonds. Although there are occasions when both stocks and bonds drop at the same time, they usually go in opposite directions. That’s what’s happened now with bonds performing better than they have in years while the stock market has been down.
None of the “losses” that people worry about have actually happened because I haven’t sold a single share of VTSAX. The fact that our account is only up 0.4% overall right now is meaningless because we don’t have to sell from both sides equally. If I desperately needed some cash, I would have sold some shares of VBTLX…at a 3-5% gain over 10 months. That’s far better than the best savings account.
Since half of our savings is in that bond fund, we could do a lot of spending before we ran out of shares to sell. We haven’t needed to sell any, except to exchange it for cheap shares of VTSAX, so we’re even better off. Eventually, those shares of the stock market fund will go back up and we’ll have the ability to sell them for a gain as well.
I think part of the reason people don’t think of doing this is we have a very antiquated understanding of how the stock market works. I illustrated this in my book, Pilot Math Treasure Bath. I’m going to use an excerpt from Chapter 6, Nuts & Bolts – Getting Started, to provide that illustration here:
Another reason that people keep too much money in savings accounts is that they don’t understand how our financial system works. They think that if a sudden expense pops up, they must have money to cover it that instant. For someone living paycheck-to-paycheck, this is terrifying and problematic. Again, we’re not those people.
If your car breaks down and you have to pay $1,800 for a new transmission, you do not have to shell out all that money that instant. Worst case, you’ll have to pay part of it up front, and cover the balance after the repairs are done. Chances are the shop doesn’t stock transmissions for every make and model of vehicle on the road. They’re going to have to order one and it’ll take a few days to arrive. Then, it’ll take at least a day to swap it out. This gives you several days to come up with the cash.
As long as you’re disciplined and you have a plan, there’s nothing wrong with using a credit card to cover this expense. As an added bonus, you’ll get at least 1,800 hotel points or frequent flier miles by paying this way. When you use a credit card to pay for something, you have 30 days to pay off that expense without having to pay any interest to your credit card company.
If you have a full month’s worth of expenses sitting in a checking or savings account, you can quickly use an app on your phone to transfer some cash to pay off your credit card bill the same day. Easy peasy! If not, either of these cases still gives you enough time to tap into your brokerage account. Instead of having your emergency fund lying around as cash in a savings account, you can be storing it as shares of VTSAX. You just sell a few shares of your mutual fund and use the proceeds to pay off your credit card.
Years ago, converting those shares back into to cash would have been a chore. You would have had to pick up a telephone (attached to the wall by a cord,) dial a 10-digit number by hand, and call your stock broker. He (probably not a she back then) would have had to call someone else and sell your shares. Then, he would write you a check and mail it to you. You would have to then drive to your bank, and wait in line, sign the check, and hand it to a person called a bank teller. Your bank would write some information in their ledger, bundle your check with thousands of others, and drive it to the local airport. From there, a small army of snot-nosed 20-year-old pilots would use a fleet of Piper Navajos to fly your check back to your stock broker’s bank…probably in the town from which he sent it. Once the stock broker’s bank got the signed check, they’d finally transfer the funds to your bank.
You should bow your head right now and thank Our Loving God in Heaven that those days are over!
Instead, you’ll be able to access your brokerage account from any computer in the world (including your phone) by going to Vanguard, Schwab, Fidelity, or your company of choice. With a few clicks, you’ll be able to sell as many shares of VTSAX as you need, all by yourself. Worst case, you’ll have to wait until the end of the day before you see cash show up in your brokerage account. You will have your regular bank account linked to your brokerage account and you’ll be able to immediately set up an electronic transfer from your brokerage account to checking.
This gives you more than enough time to have the money ready by the time the repairs are completed later this week, or to pay off your credit card by the end of the month. Thanks to modern technology, money stored as shares of VTSAX is as good as liquid for anyone disciplined enough to properly use a credit card.
Holding savings in a Vanguard brokerage account is neither difficult or volatile. If the stock market is down, I can get money by selling bonds. And when the stock market is up, my money works far more effectively on my behalf than it ever could in a savings account.
Vanguard let me link the checking account from my regular bank to their website. If I want to invest new money, they can pull the funds directly from my account at my bank. If I want to sell some shares, I can tell Vanguard to send the money to send the funds directly to my checking account the moment my shares get sold. In most cases, the money is in my checking account the same day I make the request.
Is it still a good idea to have a cash emergency fund for unexpected expenses? Sure. My wife and I keep enough cash on hand to cover 1-2 months spending at all times. However, even that is probably overkill. If we really needed money on short notice, we could use a credit card to pay. With credit card billing cycles running 30 days, we’d have plenty of time to get money from our Vanguard account and pay off that bill. (In the meantime, we’d earn travel rewards points for using the credit card.)
In my opinion, this is no less accessible than a traditional savings account. By splitting our savings between stocks and bonds, we give ourselves two different pools of money to draw from. The bond market generally performs at least as well as any “high-yield” savings account, and it does even better when the stock market is down.
Coronavirus has hammered stocks lately, but I have no doubt they’ll continue their inevitable climb. When they do, our overall return will be far better than any savings account could possibly manage.
We have plenty of time to wait on using our house payoff fund until that happens. In the meantime, the bond side of our account provides a great, volatility-resistant emergency fund. However, one day our account balance will be large enough to wipe out our entire mortgage all at once. We’ll be able to say, “To hell with the battle axe. Let’s hit that mortgage with a 24 tons of bombs!”
Are you dithering and arguing over tenths of a percentage point in a savings account? Are you debating whether to pay your house off early or not? Just stop. Take a look at starting a regular brokerage account. Balance it between low-fee stock and bond index funds and just start pouring money in. Draw from the money that’s up in case of emergency. Otherwise, just keep filling it up until you can do this with your dollars: