WHY YOU SHOULD THINK TWICE ABOUT A CD
Diversified portfolios can perform better against CDs long term.
In this article:
- High-yielding CDs may seem attractive now, but money in those CDs will have to be reinvested, sometimes just after a year or less, and yields may not be as high then.
- A diversified portfolio of stocks and bonds can outperform a proxy for CDs over time.
- Patience may be needed for a diversified portfolio in the short term, but we believe it can be a more effective way to help achieve long-term financial goals than CDs.
On their face, CDs may seem appealing. They carry attractive yields thanks to a series of interest rate hikes by the Federal Reserve. In addition, a CD is protected by the FDIC’s deposit insurance, which provides $250,000 of coverage per depositor, per bank and per deposit type.
It may make sense to put a portion of your cash reserves into CDs, however, CDs can have serious drawbacks. For example, if you put your cash in a CD in lieu of your retirement portfolio, it can put your retirement goals at risk if you need a certain return to meet your goals. Also consider liquidity. Your cash is typically locked in for six months or more when you invest in a CD, so consider the factors below and consult with your financial planner before investing in this savings vehicle.
Investing in a cd vs. A diversified portfolio
These days, some one-year CDs are sporting 5% annual percentage yields or more. But after one year, you need to reinvest that money and who’s to say available yields won’t be below 5%? At that point, it’s possible your return would have been higher if you had just invested the cash in a diversified portfolio.
The average yield of one-year CDs was around 1% or below between 2009 and 2022.
Let’s say we use Treasury securities with one-year constant maturity as a proxy for one-year CDs. The yield of Treasury securities with one-year constant maturity has been highly correlated with the Bankrate.com US 1-Year CD High-Yield Rate Index over time. (CD performance for the long-term timeframe sought was not readily available.)
Then, let’s compare the return of the one-year CD proxy since 1959 to the performance of a group of securities representing 60% stocks and 40% bonds. The 60/40 security mix outperforms the proxy for the one-year CD. The 60/40 mix also outperforms inflation, but the proxy of the one-year CD does so a lot less.
The Strength of a Diversified Portfolio
Sources: Ibbotson SBBI, Morningstar Direct, Bureau of Labor Statistics as of 9/30/2023
The green line represents a diversified portfolio using the weighted-average return of each asset class proxy in the following proportions: 50% consists of U.S. large-cap stocks (IA SBBI US Large Stock TR Index), 10% U.S. small-cap stocks (IA SBBI US Small Stock TR Index), and 40% Ibbotson U.S. intermediate government bonds (IA SBBI US IT Govt TR). The blue line represents U.S. Treasury securities with one-year constant maturity. The orange line represents U.S. inflation (not seasonally adjusted), which is the rate of change of U.S. consumer goods prices.
Although past performance will not guarantee future results, we believe a diversified mix of securities is better suited to help deliver the returns needed to achieve long-term financial goals, like a comfortable retirement. This strategy takes advantage of a basic principle of investing: Higher risk can provide higher return. We should note that there is also a potential for losses in the short term for any diversified portfolio, so seeking these higher returns requires patience and a long-term investing horizon.
Taxes and inflation curb cd income
Something else to keep in mind: CD income is taxed at the ordinary income rate. Any taxes chip away at your CD’s income. Also, depending on your tax bracket, the tax you pay on the CD’s income could be a higher rate than the long-term capital gains tax you may have had to pay if you sold investments in your taxable portfolio to fund the CD. Inflation also chips away at a CD’s income. If inflation is running above 3%, that makes the 5% yield less impressive.
Will you miss opportunities?
Standard terms for certificates of deposit are between three months and five years, but during the term, you are not able to access this cash. Always understand the rate you’re getting versus other opportunities and the CD’s investment terms. If you took money out of your stock allocation and placed it in a CD, then during the CD’s term, that cash will not experience the stock allocation’s returns, which may have outpaced those of the CD. Ultimately, the move into a CD may put you behind in your long-term goals, not ahead.
CDs can have their place in financial planning, and it may make sense to put a portion of your cash reserves in a CD. If you’re considering investing in a CD, talk with your financial planner first to make sure it will help and not hinder achieving your long-term goals.