Safety and Income: Banks
By Brian Perry
There are many investment options available at the local bank. Because they specialize in savings and investment alternatives that are designed to provide safety and income, banks can be a great place to store rainy day funds or cash that might be needed in the not-too-distant future. Although many banks also offer brokerage services, these services function similarly to those found at standalone brokerage firms, so in this chapter of the tutorial we will focus on traditional "bank products" as opposed to stocks, bonds or other products that might be sold through the bank's brokerage unit. This chapter will also examine the benefits and drawbacks of traditional bank products when compared to brokered products.
Savings and Money Market Accounts
The most common investment alternative available at the bank is the savings or money market account. These accounts are often linked to a checking account. However, while checking accounts are designed to fund ongoing expenses, the savings or money market account is designed as an investment tool to collect excess funds. Benefits of a savings or money market account include easy access to funds, safety and familiarity. However, they generally provide very low returns and over time may not even keep pace with the rate of inflation. (See our Money Market Tutorial for more on the topic.)
Certificates of Deposit (CDs)
Certificates of deposit (CDs) are alternatives to savings and money market funds. With a CD, an individual deposits money in the bank and agrees to keep it on deposit for a stated period of time. The maturity of CDs can range from very short (one month) to fairly long (five years or more.) Regardless of the maturity, the two defining characteristics of the CD are that the money cannot be accessed prior to maturity (without penalty) and the rate of interest is usually higher than on a money market account.
CDs provide an attractive alternative for individuals saving for a rainy day or an anticipated future cash flow. Using CDs allows an individual to earn a slightly higher rate of interest than if the money had been left in a savings account and also helps remove the temptation to spend the money before it is truly needed. CD rates vary widely from bank to bank so it often pays to comparison shop before depositing money into a CD. (If you're looking for bigger yields with limited risk, callable certificates of deposit (CD) might be right for you. (Learn more in our article Callable CDs: Check The Fine Print.)
Benefits of Bank Products
For investors concerned with safety, the most important benefit of investing at the bank is the principal protection that many of these alternatives provide. Many countries protect bank depositors against losses in order to guard against the possibility of a run on the bank and accompanying financial crisis. In the U.S., this protection comes in the form of FDIC insurance. FDIC stands for Federal Deposit Insurance Corporation, and the FDIC guarantees all deposits up to a certain level. Historically, the insurance amount has been $100,000, but in 2009 the insurance amount was temporarily increased to $250,000, and is scheduled to go back to $100,000 in 2014. This means that bank deposits, money market accounts and certificates of deposit are guaranteed by the U.S. government, making them among the safest investment alternatives an individual might consider. (Learn if your assets will be protected if your bank goes belly up, in Bank Failure: Will Your Assets Be Protected?)
Another advantage is that an individual often already has a relationship at the bank through a checking account, mortgage, or credit card. Therefore, using bank investment options does not require finding another firm with which an individual is comfortable doing business. Furthermore, consolidating one's finances in a single location reduces the number of monthly statements and makes it easier to view an entire portfolio in a holistic manner. Finally, banks are often very well known in the community and a sense of familiarity can provide comfort to individuals unfamiliar with some other investment options.
While investing at the bank provides many benefits, there are also some drawbacks to consider. Because banks primarily focus on very safe, short-term investment alternatives, the returns that they offer are generally low. Therefore, while some of the options available may be appropriate for investors primarily concerned with safety, investors interested in portfolio growth may need to look beyond the bank. Investors interested in income may also find that although there are attractive alternatives at the bank, better possibilities may exist for those investors willing to consider brokerage products.
A second drawback of investing in a bank is that many of their offerings suffer from a lack of liquidity. While brokered products (stocks, bonds, mutual funds) can generally be sold if an investor decides to reallocate their portfolio or needs the cash, many bank products do not have a secondary market available. This is less of an issue with money market accounts as an investor can simply request a disbursement from their account. However, in the case of CDs, investors who want their money prior to maturity often must pay a penalty for doing so. Penalties vary, but they can include the loss of interest earned on the investment, thereby negating the benefit of purchasing the CD in the first place.
This chapter has examined the role of bank products in an investor's growth and income portfolio. Investors with small portfolios may find that the bank is an attractive starting point for an investment program. These investors can use money market funds or certificates of deposit as they begin to build their savings, later on expanding into other investment alternatives. Investors with larger portfolios should probably only consider bank products for a portion of their investment portfolio. In addition to bank products, these investors will want to purchase stocks, bonds, mutual funds and other investment products through a brokerage firm. These brokered products often offer greater return potential and may have comparable principal protection. Therefore, brokered products should make up the bulk of most portfolios. Investors can then use the bank for money market funds, certificates of deposit, and other short-term cash investments.
The endowment effect describes a circumstance in which an individual ...
The self-enhancing bias is the tendency for individuals take ...
Gamification describes the incentivization of people's engagement ...
Anchoring and adjustment is a cognitive error described by behavioral ...
Sample size neglect occurs when an individual infers too much ...
Tools, policies, and procedures used by actuaries when examining ...
Understand the basics of the positive volume index and how investors in the forex markets use this contrarian indicator to ...
Learn about alpha and the Treynor ratio and how these metrics are used to assess investment strategy by comparing portfolio ...
Understand the basics of calculation and interpretation of standard deviation and how it is used to measure risk in the investment ...
Find out how and why mathematics are used in microeconomics, what its limitations are and the kinds of math skills that economics ...