What To Do When Rates are So Low?

I received to queries last week of people asking me what they can do with their cash (emergency fund) now that interest rates are so low.  Most of the internet based banks are offering rates of around 1% while conventional brick and mortar banks tend to offer rates closer to 0%, with money market funds somewhere in between.  This is definitely low and a concern for those, like retirees, that are depending on interest income flows.  However, in my many years of watching the markets, I’ve noticed that people tend to lose the most money in two environments: 1) A raging bubble, like the dotcom bubble or recent real estate bubble, where everyone feels they are left out and must buy something right away; and 2) a very low interest rate environment where people are reaching for greater and greater yield which tends to correlate with greater and greater risk.  Here’s what I am doing:

–I’m reminding myself of the purpose of cash accounts — the primary purpose of holding things in cash is to avoid investment risk and principle loss. It’s usually good to have a reasonable percentage accessible (meaning no penalties for withdrawal) in case of a real emergency.  Most higher risk investments do not have these options.

--I review any higher yielding investments with extra scrutiny — banks must be FDIC; amounts per bank must be below FDIC limits; money market funds must not have odd derivatives and options; and must have an acceptable minimum credit rating for commercial paper and CDs.

–I make sure that the rest of my portfolio is fully invested — typically large cash holdings and low interest rates means that there is a lot of liquidity in the market, but that many people are too spooked to invest.  This generally means that several days of stock market rallys will draw these hesitant invstors in.

--I do keep abreast of new investments — There are now a lot of investments, such as emerging market currencies, ETFs, that were not available a few years ago. However, almost always these incur market risk and principle risk, thus I only invest in these with my non-cash portion of the portfolio.

–I make sure that my cash balances do earn some rate of interest — right now ING Direct has a rate of 1.1% on their savings accounts.  Compared to nil for most checking accounts, this is better, so I do manage the cash account to at least earn the 1.1%.

shared at this week’s Carnival of Personal Finance