One of my underlying financial philosophies for wealth building is to effectively combine saving and investing activities (hence the name of this blog) to create a viable source of passive income thereby enabling financial freedom. Your savings must work for you to provide passive income and this can be only be done via investing. Over the last few years there has been a lot of talk and promotion around high yield on-line savings accounts which currently offer on average a 3% risk free rate of return (pre-tax) on your cash. However, with inflation running close to 4% the after tax rate or return for these high yield on-line savings accounts is less than inflation. This means that the value of the funds you have sitting in these accounts are losing value over time - you are in effect getting poorer.

Many people use these accounts as their only form of investment by saving all their "cash" there and watching the interest payments come in every month. One of the best marketing tricks around is the payment of this monthly interest which shows your money growing, when in real terms it is not. Given average property or stock market returns have been 10% or more in the medium to long term, these online "high" yield accounts are relatively not a very good investment option.

Yet I have 2 of these accounts myself - one with HSBC Direct and the other with ING Direct. Why would I do this if I am a sensible investor and from what I have said above. Well for three reasons really:

1.They pay more than standard bank checking or saving accounts and have no investment risk as most are FDIC insured. So rather than get 0.2% in my checking account, I am at least getting 3%. You always need cash (liquidity) to pay bills etc and so you need cash available quickly.

2. They are convenient and easy to manage. My paycheck goes straight into them. I can then make a decision as to where I want to invest.

3. Sometimes when markets are very volatile they are a good place to hold cash in the short term, before I make the decision to invest.

The point is that these type of accounts are the safest and easiest way to manage your savings (and perhaps your emergency funds) - not your investments. Letting your cash sit and grow in these accounts is a big mistake in the medium to long term because it is effectively eroding your net worth. The amount in these online savings accounts should at most compromise your emergency funds (3-4 months of expenses) and your monthly cash flow needs to pay bills and credit cards (1-2 months of pay). You should be looking to invest the rest in more effective ways. Now I know the markets are rocky and it is putting off investors, but there are still much better investments out there and you need to take a longer term outlook when investing. Here are some of the key types of investments you should be looking to make (in order of risk/return)

- Money Market funds. You can earn 3-4% on these and are almost as convenient as standard online high yield accounts. I use Vanguard because of its low fees but T. Rowe Price and Fidelity both have money market accounts. Just look for the one that provides the best rate and the lowest fees.

- Mutual or Index Funds and ETFs - Not sure which stock to pick and want diversification? Well, then invest in a mutual fund, index fund or ETF. The financial institutions I mentioned above provide a vast array of low expense mutual and index funds. I would suggest picking 2-3 funds that provide International Exposure, Large Cap American and Resources/Emerging markets exposure. I will go into some detailed names in upcoming posts.

- Stocks - The riskiest of the lot, but with the potential for the highest returns. You may be scared off by the market volatility out there now, but this could be the best time to get into some quality blue chip stocks. My suggestion is to pick well known large stocks like GE, IBM, Boeing and Walmart. They are the most likely to whether any down turn and grow into the future.

* There other categories of investment like property, commodities and derivatives, but those are outside the scope of this article.

So there you have my high level perspective on saving and investing using Online High-Yield Savings Accounts. They are the best option for parking your short term savings, but should not be thought of as an investment towards your financial freedom. What are your thoughts?

Related Posts:

HSBC versus ING Direct online savings accounts

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