Sunday, October 17, 2010

CD's Aren't As Risk Free As You Think

The humble bank Certificate of Deposit (CD) is making a comeback.  For most of the 1990's and 2000's CD's were the minivan of the investing world:  safe, secure, but oh so lame.  If you really wanted to be an investment fashionista, you'd bought dot com stocks, real estate, exotic options, and ETF's.  A CD investor was a boring clod who either was too dense or too fearful to put their money in "big boy" investments.

But then all of the big boy investments tanked, and now CD's are cool again.

People are flocking to CD's in large numbers, thinking that they are a safe haven from the wolves of Wall Street.  Despite the low interest rates that most CD's pay, the protection that they offer more than makes up for the paltry returns for most people.  However, I am here to throw some cold water on the CD party.  They are not as risk-free as they seem. 

CD's are relatively simple investment products.  You give some amount of money to a bank for a period of time, and the bank returns your money with some amount of interest thrown in.  If you decide you want your money back before the time of the CD expires, you pay a penalty, which usually amounts to losing some or all of the interest that you would have earned had you left the money alone.  One last key characteristic is that the interest rate is fixed for the length of the CD.

[Note:  There are some CD's which offer the ability to reset the interest rate, but usually these CD's pay a lower rate of interest and this option is usually a one-time deal].

So what makes a CD risky?  After all, you can't lose your money, right?  Yes, that is true, but what makes a CD truly risky is that fact that your interest rate is locked in.  What happens if interest rates rise while your money is locked up in a CD?  If that happens, you will be missing out on the higher interest rates because your money is locked up at a lower rate.

Why does this matter?  After all, you are still making some amount of interest, and you aren't going to lose your intial stash.  The problem is that usually when interest rates rise, inflation rises too.  That means that the money that you put into the CD is going to lose purchasing power.  When the CD comes due, the money that you get out at the end will buy less than it did when it started.

Here is an example of what I am talking about.  According to bankrate.com, the average 5 year CD pays an annual interest rate of 1.63%.  That means if you deposited $10,000 into the average 5 year CD, you'd end up with $10,842 when the CD matures.  Not too shabby, right?  However, let's say that during that 5 year period, the average annual inflation rate jumps to 5%.  That means that your $10,842 in five years will be equivalent to $8,595 today.  That is because the prices of everything will have jumped 5% per year.  You've just lost 14% by investing in a CD!

This is a just a hypothetical example.  There is no guarantee that inflation is going to go up and everything will cost more in five years.  However, it illustrates that CD's aren't as riskless as you think.  What can you do to protect yourself from this situation?  Here are some possibilities:

1. Put your money into short term CD's.  If you invest in a 1 year CD, you have an opportunity to reinvest your money after a year at a higher rate if inflation is higher.  Generally, when inflation goes up, CD rates go up as well.

2. Buy CD's of varying maturities.  The flip side of example I gave above is the situation where interest rates are falling.  If interest rates drop, you would have been better off locking in a higher rate for 5 years.  Of course, nobody knows what interest rates will do from year to year.  Therefore, to hedge your bets, so to speak, you can put your money in CD's of varying lengths.  If interest rates rise, you can take the money from your shorter duration CD's and reinvest them at the higher rate.  If interest rates fall, the money in the longer duration CD's will continue to earn a higher rate.  This is just another form of diversification.

The bottom line is that when you invest in a CD, you are locking yourself into a fixed interest rate.  This can be good or bad depending upon what direction interest rates move.  This risk is something to consider before you invest in a supposedly risk free CD.

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