Certificates of deposits, aka CDs have long been a stable part of my overall investment portfolio. Whether it was a bull market or a bear market, I would always invest roughly 30% of every dollar saved in the longest CD possible since college. Although I lost around 30% of my net worth during the worst of the crisis in 2009, I knew that even if everything went to hell I’d have at least 30% of my net worth intact. The feeling was very comforting, especially when yields were over 4%.
Unfortunately or fortunately, times have changed due to the Fed’s stance on keeping rates low until 2016 if not much longer. I strongly believe that low interest rates are here to stay for a while. We’ve still got a lot of economic slack in our economy to keep significant inflation at bay. Policy initiatives are also much quicker and more effective thanks to technology. As a result, everybody should:
1) Refinance their mortgages, call their credit card companies, and consolidate their student loans. Refinancing a mortgage or locking in a new mortgage at current low rates is a no brainer given the Fed has signaled they will be raising interest rates in 2016 and beyond.
2) Be more amenable to taking on debt at the margin to build wealth e.g. buy real estate, invest in a business.
3) Look at all other investments besides CDs.
The best CD interest rate I can find is 2.2% for a 10 year CD in 2015. The funny thing is, 2.2% is not bad given the 10-year yield is at around 2.2% as well. It’s better to lock up your money for only five years versus 10 years, after all.
ALWAYS REMEMBER EVERYTHING IS RELATIVE IN INVESTING
When you have a 10 year CD or 10-year Treasury bond providing a ~2% return, your hurdle rate is very low. There is a good chance a monkey can randomly choose 10 stocks to build a portfolio that will beat these returns if history is any guide. The dividend yield of the S&P500 alone is around 2% for goodness sake.
My conservative investment target return has always been around 2-3X the risk free rate of return. With the 10 year treasury yield likely staying below 2.5% for a very long time, I’m shooting for 4-6%. The problem is, no CD provides even close to a 4% return. As a result, we need to move up the risk curve.
As my 5 year and 7 year 3.5%-4.5% CDs start rolling off in 2014, I do not plan to renew at 1.5%-2%. Instead, I’m doing research now to invest my money in what will hopefully be much greater returns. Given CDs are part of my risk adverse portion of my overall portfolio, I need to be careful not to invest too far outside my risk tolerance. The rest of my portfolio is split 35% in real estate, and 35% in stocks, excluding all other assets. This mix will start changing as you’ll read below.
To recap why I’m not investing in CDs:
* Highest rate available is a 10-year, ~2% yield.
* CDs yields barely keep up with inflation.
* Locking up money for 7-10 years for under 2.5% does not sound appealing, especially with an early withdrawal penalty.
* If there is significant 3-5% inflation due to so much monetary easing, CD rates will rise.
* The S&P 500 dividend yield is also around 2% and I’m bullish on the stock market.
* Chances are higher we should be able to outperform a 2% return in many other asset classes.
TOP CD INVESTMENT ALTERNATIVES
High Interest Savings Account. The benefit of a CD used to be a much higher interest rate compared to a savings account in exchange for locking up your money for years. Normal spreads were easily 2-3% (200-300 basis points) e.g. 4% yielding 5 year CD and a 1.5% yielding savings account for a 2.5% spread. Even with the national average savings account yield of 0.1%, the spread between an average 5 year CD yield of 1.75% has narrowed to 1.65%. In other words, the return on locking your money up for a long period of time has declined, or the opportunity cost of investing in long term CDs has increased.
A 1% savings rate where you can freely access your money without penalty is a no brainer compared to locking your money up for 5-10 years at only 2%. Online banking is the best place to park your cash and it’s very convenient to deposit or withdraw money. Don’t let traditional banks get away with paying you nothing in interest as you fall way behind due to inflation! I’ve got $50,000 in an online savings account yielding ~1%.
Online savings banks can offer rates much higher than bricks and mortar banks because they don’t have the same overhead costs. Accessing your money online is easy. But having your money in an online bank also helps take away your temptation to always spend.
Peer-to-Peer (P2P) Lending. P2P lending has been around since 2006 and has finally started to go mainstream. The genre is regulated by the SEC and there are now loans worth over $1 billion in P2P land. I’m investing my money with Prosper.com, which advertises an average 10% return on investors since 2009 who are diversified with over 100 notes, and $2,500 (100 notes at $25 each).
The average returns range from 5.49% for lower risk, AA rated borrowers up to 12.46% for high risk, HR rated borrowers. As my goal is to beat the risk free rate of return by 3X, investing in AA rated borrowers for a 5.49% is actually a perfect alternative! When I decide to get more aggressive with P2P lending, I’ll move up the risk curve. I don’t expect the total return of the stock market (returns + dividends) to average more than 8% a year for the next five years. If we do get 8% a year, we should all consider us lucky. As a result, once I get a proven track record of ~5-6% returns, I will invest more.
The Stock Market / Dividend Stocks. Investing in the stock market is the riskiest CD alternative, but it’s also straightforward thanks to retirement savings vehicles such as the 401k, IRA, as well as online brokerage accounts such as E*Trade, where I’ve been a customer for the past 11 years. Investing in the stock market is not a comparable alternative to risk-free CD investing at all as we learned during the recession. That said, low interest rate returns on CDs force us to move up on the risk curve.
30% of my net worth is in CDs because I’m content with 4% risk-free returns. 35% of my net worth is in real estate because although real estate is a fantastic way to build long term wealth, real estate is leveraged risk. No more than 35% of my net worth has ever been exposed to the stock market because the 1997, 2000, and 2009 implosions destroyed tremendous wealth and sent many friends to the poorhouse for going all-in at inopportune times.
If my 8.8% return prediction holds true for the S&P 500, then it behooves me to allocate more of my net worth towards the stock market and away from low risk investments. A 6.8% buffer (8.8% – 2%) should be enough to compensate for risk. Companies are raising their dividend payout ratios more aggressively, meanwhile bonds look as unattractive as CDs. Just remember you can and will lose money in the stock market. It happens to the smartest investors who dedicate their lives to investing. The best thing we can do is have a balanced portfolio that matches your risk tolerance.
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Debt Repayment Of Any Kind. It’s generally better to take on debt in a low interest rate environment rather than pay off debt. However, if you have legacy debt that has a stubbornly high interest rate which cannot be lowered, then paying down debt is the safe alternative. Examples of legacy debt include student loans and mortgage rates at over 4% and any type of credit card debt.
A 4% interest rate might not seem like a lot, but when the current risk free rate is less than 2%, 4% is a lot. Remember to always think in relative terms. Besides the economics of paying off debt, there’s also a positive mental benefit as well. I paid off my 2.75% business school loan debt early because I simply found the debt annoying. Getting rid of the burden felt tremendously satisfying.
Do note that refinancing your mortgage to a lower rate is considered debt repayment. During the refinance process, a bank literally pays off your entire existing loan and gives you a new loan with a better rate in its place.
Structured Notes. Structured notes is a derivative of straight equity investing in the stock markets. Structured notes are a great way to protect your downside while participating in some upside albeit capped. The risk to structured notes lies in the viability of the issuer. If Citibank goes bankrupt, owners of structured notes become a creditor. There is no $250,000 FDIC insurance per individual. Below are three examples.
Example: S&P 500 35% downside barrier note with a 24% guaranteed return or greater after 5 years. Let’s say the S&P 500 is at 1,360 when you spend $100,000 for the note. Unfortunately the economy is horrible and the S&P500 goes down by 20% to 1,088 during the note’s 5 year time frame. When the note comes due, because the S&P500 is down less than 35%, you collect $100,000 principal back + $24,000. If the S&P500 is actually up by 50% during this time period, you collect $100,000 principal back plus $50,000. The downside is the five year lock up and no dividends. If all goes well, it’s like getting at least a 5% annual return + upside. See chart below for details.
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SAYING GOODBYE TO CDs IS NOT HARD TO DO
With CD rates so low and alternative investments relatively more attractive, it’s hard to argue a strong case for investing in CDs anymore. Perhaps if you are super risk adverse, already in retirement, and have no other passive income whatsoever, CD investing is appropriate. However even then, a 70 year old can find greater returns in often criticized annuities.
I do not include real estate because it is not a proper comparable given landlords must actively manage their properties in person. The CD investment alternatives must be as low maintenance as possible where even if you disappeared off the face of this earth, the returns will still keep coming. If you want to take a baby step, definitely park your money in an online bank at a higher interest rate. You’ll not only earn more money, but you’ll also protect yourself from spending temptation.
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About the Author: Sam began investing his own money ever since he first opened an online brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college on Wall Street. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 35 largely due to his investments that now generate over six figures a year in passive income. Sam now spends his time playing tennis, spending time with family, and writing online to help others achieve financial freedom.
Updated for 2017 and beyond.