(Today’s guest post comes to you from David Rosenstrock, who is a certified financial planner with an MBA and the Founder of Wharton Wealth Planning, LLC.)
Editor notes: As interest rates rise and certificates of deposit (CDs) have a reasonable interest rate again, (back to normal) many investors are flocking to buy them. But should the new interest rates cause anyone to change their investment allocations between stock/bond/cash? Today’s guest post provides some insight as to why one should or should not consider making changes. Have you made any changes?
Many individual investors have recently demonstrated a strong appetite for various cash instruments (such as CD’s), especially as yields have been rising.
It is important to note, however, that it may not be the best idea to over-allocate to cash right now. Below are some key advantages and disadvantages to think about with respect to cash holdings today.
Advantages of Bonds Over Cash
Given where cash interest rate yields are, what is the case for bonds right now? There are a couple of key advantages.
One is that when you purchase bonds and longer maturity fixed income investments, you are able to lock in a higher yield for longer. So, if you buy, a five-year bond or a 10-year bond, that means that interest rate will prevail over your holding period.
Another key advantage is that you do have some appreciation potential with fixed-income instruments, which is something you do not have with cash interest rate instruments. You don’t have principal volatility with a CD, but that goes both ways. You can’t have losses with a CD, but you can’t have gains, either. As we think of rates potentially going lower in the future, the fixed-income investor stands to benefit potentially from some appreciation in such an environment.
Advantages of Stocks Over Cash
What are some advantages of stocks over cash related investments such as CD’s?
Stocks have unlimited upside potential. When we look at the asset classes that have had the best long-range opportunity to outrun inflation, stocks have done that compared to other asset categories. This is important as you are thinking about your future and allowing for growth in your investment accounts. The main disadvantage of stocks, of course, is significant principal volatility potential. Cash accounts, in general, allow you to avoid risking any principal.
How should you divide right now between cash, bonds, and stocks?
In general, we recommend a combination of stocks, bonds, and in certain instances cash or cash-related investments. The right percentages and investment selections should be customized and depend on your personal situation and circumstances.
Some Additional Thoughts and Questions We have Been Asked on CDs In Today’s Economic Environment
Why are many long-term CDs now offering lower yields than shorter-term CDs?
Short-term CD rates have been higher than long-term CD rates because inflation is expected to be on the decline in the near term (relative to where it is today). Interest rates have a strong correlation with inflation (real yield). The concept of real yield refers to the rate of return that a fixed income investor earns from interest payments after factoring in (or subtracting) the inflation rate.
An inverted yield curve is when shorter-term rates pay higher real yields than longer-term rates. It can signal a recession, uncertainty, and inflation. An inverted yield curve occurs when near-term economic uncertainty or risks increase.
Are rates still high enough to justify saving in a long-term CD, and what benefits can someone receive from investing in a long-term CD?
If you have a short term need for cash (6 months to a year) then CDs can be appropriate investments as you don’t have to be exposed to principal volatility. The short term can be very difficult to predict, especially in the global geopolitical environment we are in today.
Generally, investors receive higher returns when they agree to commit their cash for longer time periods of time. The yield curve is considered “normal” when longer-term bonds yield more than shorter-term ones.
It is also important to note that a shorter-term CD, which pays a higher interest rate today than a longer-term CD, will expose you to more reinvestment risk or the risk of having to reinvest the short-term investment proceeds (potentially at reduced interest rate returns) when its investment term end. All CDs have reinvestment risk but based on the term of the CD this risk will vary.
Investors need to also keep in mind that CD’s (short and long-term) are generally taxed at ordinary income rates and this can eat away at a lot of the ‘stated’ yield an investor expects to receive. So you should look at after tax returns when assessing a CD versus other investment opportunities.
David Rosenstrock, CFP®, MBA is the Director and Founder of Wharton Wealth Planning (www.whartonwealthplanning.com). He earned his MBA from the Wharton Business School and B.S. in economics from Cornell University. He is also a CERTIFIED FINANCIAL PLANNER™.
