Since May 2022, the Reserve Bank of Australia (RBA) has raised interest rates from their historic lows of 0.10% to 4.1% today.
Naturally, with rising rates it might make sense to place your money in a savings account. However, over the long-term this might not be the best strategy to build your wealth and ensure you’re actually not losing money.
In this article we explain when is the best time to use a savings account and how best to invest for the long-term.
Why were interest rates so low and why are they now rising?
Since 2011, interest rates had been falling in Australia due to lower consumption, weak wages growth, low inflation and high household debt. Economies were slowing down and people were spending less.
In light of these circumstances, the RBA responded by gradually lowering interest rates, which has encouraged spending, lending, investing and borrowing.
In early 2022, the RBA responded to growing inflation by using the main tool at its disposal – interest rates. As inflation grew, the RBA lifted rates to help curb spending and runaway prices.
What do higher interest rates mean for my savings account?
To answer that, we should first think about why you need your savings to grow in the first place. Isn’t it enough that you’ve put some money away?
Unfortunately, no. Let’s start with a simple example. If you put $10,000 in the bank, you can be assured it’s safe and you’ll still have $10,000 if you decide to withdraw it in 10 years.
The problem is, in 10 years, things will cost much more (see The Reserve Bank’s Inflation Calculator to test this theory), and your $10,000 won’t be able to buy you as much.
That’s why high interest savings accounts were seen as an effective way to protect the value of your money. If you left that $10,000 in a high interest savings account and didn’t touch it, it would appreciate a little bit more each year.
This was a great strategy when interest rates were higher. These days, that same high interest account might give you a return of anywhere between 2% and 5% per year. And that’s before tax, which could cut that return in half again if you’re in a high tax bracket.
Essentially, Australians simply stashing cash in a high interest savings account are likely to see the value of their hard-earned money fall in comparison to the rising cost of goods and services (i.e. inflation).
If inflation is at 6% and your savings account is paying 4%, you have effectively lost money. And that is without factoring in taxes and transaction costs. It is only through investing for the long-term do you have a chance at sustained wealth creation.
When to use a savings account
A rule of thumb for when to use a savings account for your investing needs is for anything short-term (three months to three years). The trick is to make sure that during this time your money is working hard for you.
If you need to access your funds in the short-term, Stockspot generally recommends placing your money in cash exchange traded funds (ETFs) like the Betashares Australian High Interest Cash ETF (ASX: AAA).
Investing in a cash ETF offers the benefits of earning regular income, whilst withstanding the volatility of the sharemarket.
Some investors use cash ETFs to help cover expenses like upcoming school fees or paying for that long-awaited holiday.
Cash ETFs have the advantage of not locking you into a set investing period and don’t come with the usual terms and conditions associated with a high interest savings account, like making regular deposits or keeping the balance above a certain amount. You also won’t be penalised for selling the cash ETF (i.e. withdrawing the cash).
Plus, cash ETFs are very liquid assets and can easily be bought and sold on the ASX.
What are the alternatives to a high interest savings account?
Over 30 years, interest rates have gone up and down, but returns on cash alone have lagged behind bonds and shares by about 2% to 4% per year on average.
That might not sound like a lot, but $10,000 left in a savings account 30 years ago would be worth about $35,000 today compared to over $135,000 in Australian shares.
If you want to grow your money in a real way, you’ll need to take some risk – and that means investing in assets like shares and bonds.
Yes, investing can be risky because the share market is volatile. Yet even with the market highs and lows over the past 30 years, the share market has still returned an average 9.1% per year in Australia and 10.3% per year in the US.
Compare cash which returned an average of 4.2% per year over the same period.
Why savings accounts are not ideal for long-term investing
One guarantee when you invest in the share market is that your account will go down in value from time to time. Sometimes the value will fall a lot and go into a bear market.
A bear market is when shares fall at least 20% from their high, of which there have been 12 bear markets in Australia since 1950. Over time shares recover from bear markets and go higher.
The 9.1% p.a. return that Australian shares have made over the last 30 years includes several bear markets including 1987, 1994, 2002, 2008, 2015 and most recently 2020.
Invest in shares for the long-term
A 9.1% p.a. return over 30 years will turn $10,000 into $135,000. If you can top that account up with another $250 per fortnight over that period you’d end up with well over $1,000,000.
How to invest for the long-term
Money in the bank will either stay static or grow by tiny increments with interest. Investments, on the other hand, go up or down on a day-to-day basis while also accruing income along the way (through distributions/dividends).
The way to mitigate your risk is to understand the tenets of good investing, and to diversify your portfolio. For the long-term, look at diversification (i.e. having a mixture of investments that complement one another) as a way to reduce your risk significantly compared to stock picking at random.
ETFs, like those offered by Stockspot, are a good option for the risk averse investor as a single ETF provides exposure to hundreds of companies.
When you have a fully diversified Stockspot portfolio, you get exposure to hundreds of different companies, but you’re also investing in other asset classes.
You’re diversifying your investments across high growth/risky assets like shares, but also more conservative assets like bonds and gold.
Stockspot recommends ETFs that are low in fees. This is important as paying just a few per cent per year in fees may not sound like much, but it could easily end up costing you more than $100,000 in the long run.
How much should I keep in a savings account?
With the savings interest rate at its current level, it might be tempting to put all your money in a high interest savings account and lock it away.
Having some money set aside for a rainy day means you don’t need to sell investments if you need money when things go wrong, as this could affect the long-term growth of your investments and you don’t want to be withdrawing when markets are down.
A rule of thumb is that you should have between three to six months worth of living expenses saved for use in case of emergencies, medical expenses, home repairs, car repairs, fines, fees and other similar expenses.
As mentioned, you can also consider a savings account for any funds you may need in the short-term (between three months to three years).
Once you have that sorted, consider investing the rest of your extra cash in a diversified manner. Consider a diversified portfolio for medium to long-term investing goals (three years minimum to more than seven years.)
If you have time on your side, your money will be able to work for you and provide you with returns over the long-term.