During times of stock market weakness it’s a common knee-jerk reaction to find as many safe havens as possible. Some are happy to keep their money in money market accounts yielding nothing. Others like to shove their bills under their mattress. I prefer allocating my truly risk-free money to a higher yielding online bank or to Certificates of Deposits. Bonds can lose value, especially if you aren’t willing to hold them to maturity.
Before the Federal Reserve started cutting interest rates, one could find very respectable long-term CDs yielding 4% or greater. If you believe the ideal withdrawal rate in retirement doesn’t touch principal like I do, then a 4% yielding CD is a suitable investment once you’ve accumulated enough. The “problem” now is that 5-year CDs are yielding at best 2.5%. Hopefully they inch higher as the Federal Reserve continues to raise rates despite evidence indicating they don’t have to.
This post will discuss deploying your capital in CDs for capital preservation versus investing more money in the stock market during difficult times. I’ve invested a portion of my net worth in CDs for the past 17 years and will continue to do so with a portion of my savings.
WHEN TO BUY CERTIFICATES OF DEPOSITS
The #1 pushback I get from people who don’t want to buy CDs is that interest rates are too low. Even when a CD was yielding 4%, people complained because the stock market was returning an even greater amount. Stock jockeys with little experience thought they couldn’t lose in 2007. Then they lost their shirts, their pants, and their Storm Trooper underwear when the stock market melted down in 2008.
After seven years of a bull market, stock investors who’ve started investing in the stock market think with the same cavalier attitude today. Why invest in a CD at 2.5% when you can find stocks that yield 2.5% with upside potential! The answer is simple. I’d much rather make a guaranteed 2.5% than lose money in a bear market cycle. Stocks lost 3% – 12% the day after the Brexit vote alone!
The main takeaway everybody needs to understand about CD interest rates (returns) is that everything is correlated. A 2.5% yielding 5-year CD does not exist in a vacuum. A CD is yielding 2.5% because inflation is low, the demand for less risky or risk-free assets is high, stock markets may be on shaky ground, and central banks are accommodative. Financial risk and reward are always entwined.
As financial freedom seekers you must balance your liquidity needs with your desire for returns. Let me suggest a mental checklist you should first complete before deciding whether or not to invest in CDs.
1) Decide how much of an Armageddon Fund you need. If you get laid off, your business shuts down, and all your other income streams die off, you are screwed unless you’ve got a large enough Armageddon Fund to hold you through until the eventual rebound. Those who did not have an Armageddon Fund did foolish things in the last downturn, like default on their mortgages and sell stock at the bottom. Think of the Armageddon Fund as the big brother of all your emergency funds. A normal emergency fund usually only provides you with six months of living expenses. The Armageddon Fund should get you through years of lean times.
My ideal Armageddon Fund size is $1,000,000 in multiple CDs yielding ~$25,000 in interest a year. I figure that if all goes to hell, I can at least move back home to Hawaii and live for free while surviving off $2,084/month until the world recovers. If I had to live off more, I’d start eating my principal.
2) Decide what percentage of your net worth should be in risk-free assets. I generally advise people to have roughly 10% of their net worth in risk-free assets like CDs. It all depends on your net worth size, your income generating abilities, your age, and your level of risk-tolerance. Generally the more greedy, stupid, or inexperienced you are, the more you will be unwilling to allocate to risk-free assets. I’ve created several fundamentally important net worth allocation frameworks for you to follow.
A larger net worth can afford you a lower percentage in risk-free assets if your expenses are under control. For example, having $380,000 in CDs, $1,500,000 in stocks, $1,200,000 in real estate, $300,000 in bonds with $100,000 a year in annual expenses is a reasonable net worth composition. Almost 10% of your net worth is in CDs, which will cover 3.8 years worth of living expenses. By then, the economy should have hopefully turned around. Thankfully, we all have the ability to cut our expenses and make our money last longer if necessary.
3) Develop a system of methodically contributing to risk-free assets. The reason why automatically contributing to your 401k to the max every paycheck is a no-brainer is because you ensure that you’re saving money before a single dollar is spent. You’ll wake up 10 years later and more than likely have over $200,000 in your 401k without really feeling the burden of saving. Therefore, for your CD contributions, you must also allocate a set amount of money hopefully after maxing out your 401k.
An easy way to go about achieving 10% – 20% of your net worth in CDs is to simply allocate 10% – 20% of your savings towards CDs. But since it’s better to build a CD ladder and shoot for longer durations to get higher yields, consider saving the CD money in a liquid online savings account until you reach a particular amount of money to deploy. The amount you deploy will once again depend on your liquidity needs and cash flow. A good figure to shoot for is at least $10,000 per CD investment.
If you are fortunate enough to get a large enough year end bonus (or maybe even a tax refund), you can allocate a certain percentage to CDs in chunks as well.
4) Mind the gap. If you decide to reach for yield and invest your $10,000+ tranches in five year CDs or longer, then you must be mindful of the five year gap. During this five year time period, your CD money cannot be touched without paying a penalty, or surrendering at least six months worth of interest income if you’ve held the CD for longer than one or two years. Once you “survive” the five year gap, you will then have CDs come due at a regular intervals if you have consistently built your CD ladder.
I consider the early withdrawal penalty beneficial because it forces me to never touch my CD money. The government realizes it’s tempting to spend money. Think how easy it is to stuff your face with desert if the cake is sitting in front of you. This is why the government also imposes early withdrawal penalties on IRAs and 401ks to help protect you from yourself. During the gap, I’m busy trying to build new income streams for financial freedom.
5) Review your cash and net worth allocation regularly. A net worth review forces you to make sure your financial plan is on track. During bull markets, people tend to throw risk out the window and invest in whatever is working. The opposite is true during a bear market. I review my net worth once a month because it’s easy to just thumbprint login to my Personal Capital mobile app. The first thing that always pops up is my Cash holdings. From there, I can see my entire net worth composition and cash flow.
WRESTLING WITH GREED AND SATISFACTION
Greed, laziness, and not experiencing difficult times are really the biggest reasons more people don’t invest in CDs. People will do mental gymnastics and say that if they invest X amount in Y company,they can make more money than with low yield CDs. Admit it. You know you’ve done it.
But I will tell you something extremely important. The pain of losing money is much greater than the joy of making more money. The more money you have, the more this feeling is true. When you’ve accumulated FU money, your number one priority is to protect your principal at all cost!
Most of us are working towards some ideal net worth and income that we feel will make us happiest ($5M net worth and $250K income respectively, according to FS surveys and analysis). As a result, we should consider various types of investments to achieve our goals.
Below are returns from a $250,000 CD I invested in in 2010. The CD is now worth $78,000 more. Each month it provides risk free income of over $1,000 a month.
Could I have made more if I dumped the $250,000 into the S&P 500? Indeed I could have because the S&P 500 is up about 60% since (~$400,000 vs $323,000). But hindsight is always perfect.
But don’t feel sorry for me just yet because I followed my investing game plan and invested more in the S&P 500 in 2010. Further, there was a priceless feeling that no matter what happened in the markets or to my risky finance job, I would come out seven years later with over $330,000.
Do not underestimate the feeling of financial security with a CD. Being able to know that everything will be OK no matter what is priceless. Since the mid-90s we’ve had the Asian crisis, Russian Ruble crisis, multiple wars, SARs, the housing crisis, and now the self-inflicted Brexit. The markets will continue to be rocky. Thankfully, if we wait for a long enough period of time, the markets recover. However, sometimes we don’t have the luxury to wait things out.
If you haven’t reviewed your net worth and allocated at least 10% of your net worth in risk-free assets like CDs, I highly encourage you to do so. Continue to also follow a disciplined investing game plan of dollar cost averaging into the market because there will inevitably be a recovery. You’ll worry less about your future, make better financial decisions, and be much happier in the process.
Summary For Why You Need Risk Free Assets:
1) You want enough money to feel financially secure during difficult times.
2) You need enough money so that you don’t panic sell during difficult times.
3) You develop the good financial habit of diversifying your assets during good and bad times.
Please don’t confuse brains with a bull market.