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What’s Riskier: CDs or Stocks?
Only a few years ago I had clients complaining about their CD rates being “only” 5% and how they remembered bank rates above 10%. And now, looking at Yahoo Finance, I see the national average for a one-year CD rate is 0.64%. But before you get too excited, let’s see what it would be like after taxes. Assuming you’re in the 25% tax bracket, you’ll have to pay Uncle Sam over 0.16% and you’ll walk away with 0.48%. But there’s more…in 2011, the national inflation rate was 3%. I often call inflation “invisible risk” because we are all bound by the number of our money (for example, say you have an account worth $100,000) when it is power purchase which is the working definition of money. So, although you earned 0.48% after tax on your $100,000 CD, although your balance shows $100,480 (I’m ignoring the compounding for now, that wouldn’t make much difference), this silver is only worth $97,480 in purchasing power. when you bought it a year ago. By buying the CD, you locked in a loss of 2.52%. And for those wondering, US Treasuries pay less than half that yield (it’s normal for US Treasuries to pay less than CDs).
For me, it’s sad. Especially because from experience I know that many retirees had saved some money, maybe in stocks and had planned that when they retired they would switch everything to CDs and live off the interest of 5 %. The idea being to move from “risky” investments to “risk-free” investments. I put it in quotes for a reason and you will see why.
All investments involve risk, but often the greatest risk is not the fluctuation of principle (or price volatility as with stocks). We all hear of the saying “buy and hold”, statistics show that most investors don’t. A majority panics out of the market – in other words, the market goes down and they sell their stocks or mutual funds and put them in cash until they stabilize. What’s happening ? The purse dives, pushes the bottom of the pool and returns to take in the air. Right now, the stock market is only about 10% off its October 2007 valuation peak (and by the way, that ignores nearly five years of dividends that are currently above 2% on the S&P 500).
You might see where I’m coming from… 2% five-year dividend totals 10%…from a price point of view, if the market is down about 10% from its peak, someone who had the worst luck in the world and bought on peak market day and just walked out would now be back where they started. In fact, they would be above their starting point if those dividends were reinvested at stock prices well below their starting point. Of course, most people wouldn’t be particularly happy to break even over a five-year period, but given the financial crisis we’ve been through and the most hostile economic environment since the Great Depression and especially since very few people entered just at the peak of the market, things are not as bad as some might guess.
The moral of the story is that while past performance is no guarantee of future results, by simple observation of history one can observe that all past market declines were eventually erased (and the current n is only 10% of being).
For me, the unspoken goal of everyone who saves money or invests money is that they want to increase their power to buy goods. Over time, principle fluctuation is not a risk if you stay invested. If you have a short investment period (less than five years) and plan to withdraw it, price fluctuation could be an issue. However, the “risk” of price fluctuation and market volatility decreases over time. If you want to reduce your risk of losing money in the stock market, just stay there longer. Isn’t that what we’ve learned over the past five years? If you could go back in time and give advice to a friend who is worried about his wallet going down, what would you say? You would tell them to hang on.
Coming back to CDs, the other side of the coin is disastrous. Historically speaking, after taxes and inflation, CD owners rarely break even (as a measure of their purchasing power). This was even true in the days of 10% CDs; it was against a backdrop of double-digit inflation. If you have a CD at 10% and Uncle Sam took 25% of it (we’ll ignore for a second that the taxes were higher then), you end up with 7.5%… take 10% off inflation and your ability to buy goods has decreased by 2.5%. That 10% CD isn’t nearly as exciting all things considered. As far as risk is concerned, this situation is simply the reverse of equities. In the short term, the 2.5% loss in purchasing power will be almost imperceptible in the first few years.
However, let’s say someone from the early 80s stuck with their CDs and locked in that -2.5% annual loss every year. Over time, this would represent a permanent loss of purchasing power of over 50% (meaning it’s not a temporary fluctuation like the stock market). Historically speaking, inflation rarely, uh, very rarely reverses course. All the while, they probably felt completely safe in the CDs as they watched their “number” grow (as in principle). But again, focusing on the main number is not the right thing to focus on. Over a long period, inflation is VERY risky because it is the only headwind that constantly blows against you. The only way to beat it is to invest in investments that typically outpace inflation and minimize those that don’t. It’s so simple.
In this article, for the sake of simplicity, I have contrasted stocks and CDs, but naturally there are many other things and methods of diversification. The other half is having a solid financial plan that helps you ride out price fluctuations. Studies have shown that simply having a written financial plan helps you do just that. Earlier I talked about going back in time and giving investment advice to one of your worried friends or even to yourself, I see a financial plan as something that helps your future self, talk to your current self.
I believe our future selves would tell us not to worry about the fluctuation of the stock market that’s not a problem over time but what is a problem is that the cost of living has gone up every year. A good financial plan reiterates your long-term goals, or if the plan says your goals are short-term, it can tell you that inflation may be less of a risk to your plans. However, in my experience, inflation is still the biggest and safest risk affecting a person’s long-term financial goals.
The opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations to any individual. To determine which investment(s) may be suitable for you, consult your financial advisor before investing. All performance referenced is historical and does not guarantee future results. All indices are unmanaged and cannot be invested directly.
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