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Let’s start this conversation about interest rates with a personal problem. I have some money in a savings account and it’s earning basically zilch. Why are interest rates so low right now?
Like a lot of things right now, it’s pretty much COVID-19’s fault. (Though, it’s also the culmination of a 40-year macroeconomic trend. Don’t worry, I won’t get into it here!) Let’s look at it from the bank’s perspective. When COVID-19 struck, lots of people rushed to put their money in a safe place like a savings account. Banks pay you money to keep your money there because they need a nice supply of cash to do what banks do. But as the supply of money available to banks increased, the less they were willing to pay you for your money.
At the same time, the government (i.e. central banks) lowered interest rates, thereby increasing the money supply available to people. This helped struggling businesses stay afloat by lowering their cost to do business, and encouraged spending, lending, and borrowing. So while this was incredibly helpful to those hit the hardest during this health crisis, your savings account has been an unfortunate casualty.
I guess I should admit here that when I hear people on the news saying, “Interest rates are at an all-time low!” I don’t exactly know what they mean. Which interest rates are they talking about?
That’s a good place to start. When the media talks about “interest rates” they’re referring to the cash interest rate. You’ve certainly heard about a rate cut or hike, right? That’s the short-term interest rate—it's the rate set by the central banks for what banks charge each other to borrow money for one day. Pretty much every other interest rate is affected by what that rate is. The government raises it? Other rates go up. The government lowers it? Other rates go down. It’s also the primary lever central banks use to try to regulate the economy and it directly affects the money supply. If a central bank cuts that rate, it will be cheaper to borrow money. There will be more money available and the price to borrow that money will be lower, which tends to make some people spend more. When the central bank raises that rate, it gets more expensive to borrow. This means there will be less money circulating, the price to borrow that money will be higher, and people will tend to save more.
So I guess my question is: should I even bother keeping my money in a savings account at this point?
Everything in investing starts with assessing what your goals are. Ask yourself: what’s that money for? If it’s cash you absolutely can’t afford to lose in the short term—because you’re using it to live on or you’re going to need to spend it soon—a savings account is still a great idea. But when I say short term, I mean a period of time you count in months, not years. See, with rates so low, you are currently earning less than the rate of inflation. The inflation rate is about 1% in Canada. That means the money you are saving will actually be less valuable over time. So, if you keep your money in a savings account for 5-10 years, you will be able to buy about 5-10% less with that money than you would when you started. Not ideal, right?
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So assuming you also have a chequing account for your monthly expenses, your savings account should only be for money intended to cover an impending big purchase, like a house or car down payment, plus, some extra in case of emergency for your psychological well-being. And no more than that.
What about stocks? How do interest rates affect stocks and bonds? Is that where I should be putting my money?
The relationship between interest rates and financial markets is complicated. I’ll do my best to explain.
First, it’s helpful to think about cash, stocks, and bonds as three asset classes that are constantly in competition with each other for your money. The big benefit of cash (and things like savings accounts) is that it has the least risk. Stocks have the most risk of the three, so they need to offer the highest returns to be attractive. Bonds need to provide returns above cash with less risk than stocks.
When interest rates for cash and savings accounts get really low, like they are now, cash becomes much, much less attractive. That means people gravitate to the riskier two assets–stocks and bonds. And while in the short term, this increases the price of riskier assets, they also become a little bit less attractive as investments because if the price of stocks or bonds increases, but their fundamentals (like the expected profits of a company, for example) don’t change, the returns you can expect are lower.
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So low interest rates are a bit of a double-edged sword for stock and bond markets. When interest rates are cut, the markets will get an immediate boost, but lower interest rates also make your expected rate of return lower in the long run. Does that make sense?
OK, so now we’ve reached the money question (pun intended). What am I supposed to do with my money right now?
Let’s get back to basics. A crucial investing principle is that if you want a return on your investment, you need to take some risk. That’s where the stock and bond markets come in. If you are willing to take some risk by putting your money in those riskier assets, you will probably earn a positive return—and more than cash—over time. But due to lower interest rates, these returns may be lower than what they might have been in different circumstances. That’s the world we live in right now. Like I said, it’s basic but it’s a pretty good bet, particularly if you invest in a diversified way.
So in terms of investing, is it business as usual? The whole world seems to be upside down. Are there specific COVID-era investing tips I should keep in mind?
I mentioned diversification a moment ago, and though it’s always been a key investing strategy, the pandemic has actually amplified its importance—particularly when it comes to international investments. The health crisis has demonstrated that a lot of governments and governmental systems around the world are under strain, even in places we thought were stable (take the institution of democracy in the United States, for example). I think making sure you are globally diversified is more important than it’s ever been.
So, to review: I’ll lose money long term in cash and the stock market is better but still not as good as it was when interest rates were higher. Neither are great news. Should I be trying to turbocharge my portfolio with some alternative investments? How about adding a little bitcoin into the mix?
Before investing in anything, you generally want to think about when the asset will do well, when it won’t, and why it will go up over time. Currently, I see the case for bitcoin as being similar to gold. There’s a fixed supply of it at a time when there’s both a ton of money cycling through the economy and scads of available credit. This particular situation tends to raise the prices of all assets, including bitcoin.
So that’s the good bitcoin news. The less-good bitcoin news is that it’s still a relatively new asset and it attracts a lot of traders and speculators. This creates really large swings in its value, but also means that, unlike gold, it’s probably not going to serve as a dependable hedge against a poorly performing stock market.
I’m trying to read between the lines here. So, ditch the bitcoin in favour of gold?
That’s not at all what I was trying to say. Gold and bitcoin are like apples and oranges. Gold has a much longer history and is much more widely used. For example, central banks around the world use it as a store of value. The argument for gold is that it can be a nice diversifier when there is a lot of fear and market instability. And as an asset with a fixed supply, it will increase in value when the government is printing a lot of money, which it certainly did earlier this year, and will likely continue doing so in the months and maybe even years to come. In fact, we have a small gold allocation in our Wealthsimple portfolios. But generally speaking, gold’s expected return is low, so I’d advise against doing anything drastic like moving all your assets to gold. Same goes for bitcoin. Treat them both as side dishes to your main course.
So what’s the upshot, Ben?
I know it’s tempting to want to change course in uncertain times, and 2020 has been nothing if not uncertain, but my general financial advice hasn’t wavered much at all from where it’s always been. Put the lion’s share of your money in a diversified portfolio of risky assets where you get paid for taking risk. That means things like stocks, which still offer attractive returns over cash, as well as diversifying assets like longer-term government bonds and gold.
And then, of course, there’s the really super basic stuff that is probably more important than any investment you make. Save more than you spend. Minimize the amount that financial services companies and the government take in fees and taxes. And though it may not have any direct impact on your financial life, remember to drink plenty of water, and always send thank you notes.
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