Investors and savers scour the landscape searching for the bank certificate of deposit that will pay them that extra one-fourth of 1 percent on their savings, while offering the peace of mind of the FDIC insurance guaranteeing them against the failure of the bank up to a limit of $250,000.
CDs, bank money market and savings accounts are always popular with savers who wish to place a portion of their funds in vehicles which are safe from market fluctuation and have a guarantee of return of principal value. When the financial markets go through one of their periods of extreme volatility, we typically see investors flee vehicles like corporate bonds and equities, which traditionally return more over time, but can go through periods of fluctuating principal value.
Presently, there is somewhere in the neighborhood of $8 trillion parked in various bank savings vehicles and money market funds, earning yields in the 0 to 2 percent range depending on the type of vehicle and the institution. Many investors seem willing to accept these very low rates until their confidence returns, allowing them to venture back to investments which have higher potential. Others use these low yielding savings vehicles as their long-term investment plan, but are blind to the high cost of the safety they seek.
Sounds strange to refer to safety as a cost, but the facts are clear. A recent report prepared by Oppenheimer Funds summarized the last 26 years (1983 to 2008) of the “real return” on certificates of deposit when adjusting for federal tax on the interest income and the rate of inflation. The analysis used the top federal tax bracket, which averaged 38 percent over the time period in question, and the average rate of inflation was 3.1 percent.
The average CD yield over the 26-year period was 5.74 percent. Adjusting for the tax rates and inflation as described abov,e the average annual real return was 0.4 percent. Real return is the actual wealth accumulation in excess of the impact of taxes and inflation. I have always maintained that CDs don’t build real wealth at a significant pace, and this recent study bears that out.
That’s not to say CDs and money market funds don’t have their place in your financial plan. For monies which have a designated purpose in a relatively short period of time or for emergency cash reserves which may be needed at any time, these very safe vehicles fit the bill. Just don’t have a lot of illusion about how much wealth you are accumulating, especially if the funds are not in tax-sheltered accounts like IRAs. Obviously, for those tax-sheltered accounts and for those investors in lower tax brackets, the results are somewhat more favorable.
Here’s an idea to consider. Without even opening up the discussion to investing in stocks or real estate. How about owning a diversified portfolio of investment grade bonds? These bonds are issued by the government, government agencies, and credit worthy corporations. The bonds do fluctuate in value in a relatively minor way, but for this minor fluctuation, there has historically been a reward – higher returns.
If we look at the Barclay’s Aggregate Bond Index, an index representing a cross section of the entire U.S. investment grade (high quality) bond market for the same time period referenced above we find an average return of 8.4 percent per year, or almost 2.7 percent more average annual return than offered by CDs.
Applying the same real return analysis used in the CD example to the bond index would reveal an average annual real return of 2.1 percent, compared to the 0.4 percent from CDs. What about safety? Yes, these bonds do fluctuate in value, but there were only two years in the 26 examined where the Barclay’s Aggregate Bond Index had a loss, and the largest of these was only -2.9 percent. So, for a moderate amount of fluctuation in principal value, a significant reward may be generated.
For sake of disclosure, investors cannot invest directly in an index. They are used to monitor the performance of certain market segments. However, there are mutual funds and exchange traded funds which copy or mimic indexes and offer a high level of diversification in one security. For most small investors, these funds are a great way to go. Of course, no one investment vehicle – bonds, CDs or stocks, makes up a complete investment plan, and investors are generally well served to use a diversified portfolio.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing.