There are so many investment options available, and if you’ve never invested before, it’s possible the one you choose won’t be the right fit for you.
I was inspired to write about this topic in response to a question by a reader. This person is someone who is looking to invest, and started by checking with his bank.
First, I love that a 24-year old is taking initiative to invest. And I also love that he’s asking a question about the wisdom of doing it with the bank.
He’s right on target asking if that’s the right choice.
What the Bank Offered this Reader for His Roth IRA Account
So when this eager, 24-year old first-time investor went into the bank, exactly what did they offer him? A nine-month certificate of deposit paying 1.59%. The banker justified it by saying it was “a lot better than the 0.35% paid on a Roth IRA”.
First, what does the banker mean by saying it’s a lot better than 0.35% paid on a Roth IRA? What Roth IRA is paying 0.35%?
A Roth IRA is a type of retirement plan, not a specific investment, and certainly not one that pays such a low rate. My suspicion is the banker was comparing it to some other in-house product the bank normally steers Roth customers into, but that’s just a guess.
Second, how is a CD paying 1.59% a good long-term investment?
Here’s my problem with the CD idea…The current rate of inflation is around 2.2%. A CD paying 1.59% is a guaranteed losing investment against a 2.2% inflation rate. The investor will lose 0.61% each year his Roth IRA is invested in that CD, or one with an equivalent yield.
Third, a Roth IRA is a retirement account, which by necessity makes it a long-term investment. The reader must accept investments with some risk in order to get returns that easily outrun inflation over the long run, especially at age 24. If he doesn’t, he’ll never be able to retire, and the whole purpose of the Roth IRA will prove to be an epic failure.
This is a full-blown investment tragedy. A young man goes into a bank to begin his life as an investor and gets set up to fail. That kind of advice is only a little better than telling him he needs to stuff his money in his mattress and earn no income at all.
What the Banker is Saying – and Not Telling the Would-be Investor
To be fair, the banker is probably just doing his job. That is, he’s offering this young man products the bank has available. In all likelihood, the bank has no investment vehicles more aggressive than CDs. As a loyal employee of the bank, the bank officer is attempting to steer this investor in that direction. It may even be that the nine-month CD is the best deal in the bank’s CD portfolio.
But that doesn’t mean it’s right for this customer. It makes you wonder how many other bank customers are similarly being directed into safe, low-yielding instruments for what should be aggressive investments.
Most banks have nothing more aggressive than CDs, so this is a likely outcome. This particular banker was probably not keen to disclose that limitation. After all, he can’t offer what he doesn’t have.
Some banks do have an investment arm, or an affiliation with an investment management firm. But even these aren’t typically the best places to invest your money either.
Bank related investment firms are run mainly like traditional financial advisors. Because they often work on commission, where they get paid to recommend certain investments, their primary interest may be in selling you something that isn’t necessarily suitable. That opens the possibility of your account being churned and the likelihood of paying high fees.
This is why I say it’s a big mistake investing through your bank. Banks certainly have their place, but not when it comes to investing.
Why People Invest with Banks
There’s no question, a lot of people like to play it safe with their money. And nothing seems safer than a bank. After all, they have the advantage of FDIC insurance on your deposits.
But from an investment standpoint, even FDIC insurance has limitations. It only insures your money for up to $250,000 per depositor. And while that seems like a lot of money, if you’re a long-term investor – particularly when it comes to retirement accounts – you should have your sights set on much higher balances, at least eventually.
The other limit is that FDIC insurance only covers bank deposits. That means checking and savings accounts, money markets, and certificates of deposit.
If you do have any money in an investment account with a bank, those funds are not covered by FDIC insurance. In fact, bank investment accounts always come with microscopic fine print making that point clear. FDIC insurance doesn’t extend to stocks, bonds, mutual funds and other true investment assets.
But the problem is public perception. Because of FDIC insurance, the investor may be persuaded that their investments are fully insured. But if your funds are invested in anything other than bank deposits, they certainly are not.
It’s also likely that some investors are drawn to banks because of their brick-and-mortar branches. Even though most investing is now handled electronically, there still might be some sense that an institution with physical branches is somehow safer than one that has few locations, or even not at all.
But when it comes to investing, perception is not reality. And that’s why investing through your bank makes little sense.
Where This Investor – and Any Other – Needs to Invest His Money
Let’s circle back to the Roth IRA. Since it’s a retirement account, it must necessarily be a long-term investment account. This is even more true since this particular investor is only 24 years old. This is the time in life when anyone should be more aggressive in their investment practices. He can assume greater risk, because he has more time to recover from market-driven losses.
So what should he be investing his money in?
At this point in his life, mostly equities. That includes stocks, and mutual funds and exchange traded funds (ETFs) that invest in stocks.
The reason is simple. Long-term, stocks outperform fixed income investments. For example, $100 invested in the S&P 500 in 1928 would have grown to nearly $400,000 by the end of 2017. That’s an average annual rate of return of nearly 10%.
10% in stocks vs. 1.59% in a nine-month CD vs. a 2.2% annual rate of inflation.
Let’s work an example:
With a reasonably anticipated 10% annual return in stocks, and an annual inflation rate of 2.2%, an investor gets a net annual return of 7.8%.
If our 24-year old investor puts $5,500 into a Roth IRA over each of the next 41 years (through age 65), his account will grow to $1,523,929 in today’s dollars.
If he invests it in the bank’s nine-month CD paying 1.59%, his account will be worth less than the $225,500 he will have contributed to the plan, after accounting for inflation.
This is why the banker’s advice is so wrong, particularly for this young investor.
Where This Young Investor – and Every Other Investor Should be Investing Their Money
Since it’s so obvious that equities are the best way to invest for the long term, the strategy should be to invest through a dedicated investment account. Fortunately, there are more of those available than ever before.
Even if you know nothing about investing, there are automated online investment platforms – commonly called robo-advisors – that will do the job for you. That includes creating a balanced portfolio, then managing it regularly. Best of all, they can do this for a very low fee, generally a small fraction of 1% of your account value each year. There’s no account churning, and no trading fees.
Examples include Betterment and Wealthfront. Another is M1 Finance
And if you do want to trade stocks, there are low cost investment brokers that are perfect for that activity. One broker, Robinhood, even allows you to trade for free.
That’s why investing through your bank is such a big mistake. There are simply better options.
Banks Have Their Proper Place for Your Money – But Not Your Investments
Now I’ve been trashing banks up to this point, which is certainly deserved if they’re giving out investment advice. Most aren’t qualified to give investment advice, and when they do, it’s usually bad advice.
But banks certainly have a purpose in your overall financial plan. If you’re looking to hold your money in a safe place for an immediate financial need – like saving for a car or the down payment on a home – banks are generally the best place to do it. They’re also preferred vehicles for emergency funds, since those need to be both safe and liquid.
That’s what the banks do extremely well, and what they need to stick to. But even then, local banks aren’t always the best choice. The interest rates they pay are simply too low.
If you’re going to save for any of these purposes, you’re generally better off with online banks. Examples include Ally Bank, CIT Bank, and BBVA Compass. They’re currently paying over 2% on savings accounts, and even over 3% on longer term CD’s. That’s a lot better than the small fraction of 1% being paid by most local banks.
Use banks for those purposes for sure. But when it comes to investing, it’s an absolute necessity to think beyond banks. Most aren’t set up to handle investing, and the ones that are often charge high fees.
The next time you’re considering where to invest your money, rethink the bank idea. Investing there is almost always a big mistake.