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Looking at roughly 0.05% for a CD to 5% for a stock portfolio. That's a huge difference in return. For example, with $10K, that's a 4.95 percentage point difference! In general, does a diverse portfolio not include CDs?

It may appear that there are multiple questions here, but the main idea I am trying to understand is why get held up in a CD or other investments, when the stock market is so juicy--in general?

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    The stock market gets to 5% on average by being +30 some years and -25 in other years. – user662852 Sep 13 '16 at 12:29
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    As with almost everything else in life, the answer for you depends on your goals, time horizon, and risk tolerance. Being too aggressive can lose your entire investment, but being too conservative will also cost you in real terms (think: purchasing power) due to inflation risk. – Greg Bacon Sep 13 '16 at 13:28
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    @Adam thats +30%, not 30 yrs. He's saying the long term average is not the same as 5% per year. – Jared Smith Sep 13 '16 at 14:36
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    @Adam my largest holding was up 43% in 2016, and 60% in 2000; and down 18% in 2008, to cherry pick highlights. S&P 500 was down 37% in 2008 and 9-22% each year 2000 - 2002. Can you handle 10% losses three years in a row? – user662852 Sep 13 '16 at 14:45
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    The difference between .05% and 5% is always 9900%, regardless of the actual amount. But that's not relevant at all. 4.95 percentage points is relevant. – I'm with Monica Sep 13 '16 at 15:09
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Another factor to consider, beyond the fact that growth and volatility go together, is that the times when many people will need to liquidate their investments will correlate with the times that many other people need to liquidate their investments, and such correlation will push down the immediate value of those investments.

While certificates of deposit have penalties for early withdrawal, one can establish up front what the worst-case penalty would be for cashing it in at the most inopportune time. By contrast, stocks offer no such assurance. Stocks sometimes have weird downward spikes that may be short-lived, but if life circumstances force one to liquidate stocks during such a downward spike the "penalty" can be much larger than on a CD.

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    I don't understand your point in paragraph one. People sell investments every day. It's not like some day everyone will retire on the same day. If people are panic selling in a down market, that's a panic sell not a necessity sell. I guess your point is that markets are cyclical and you may want to sell at an inopportune time, but point one doesn't represent that. – quid Sep 13 '16 at 16:50
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    @quid: If many people lose their jobs simultaneously, they will shift from putting money into investments to taking money out of them. Most people aren't going to liquidate all their stocks immediately upon losing a job, but the changing balance between investment and liquidation will tend to reduce the prices received by those who have to liquidate. – supercat Sep 13 '16 at 16:55
  • "By contrast, stocks offer no such assurance." There is though. It costs more, but there is such a thing that exists. – adamaero Sep 13 '16 at 21:37
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    @JoelSnyder I assume Adam was referring to something like puts, which definitely do have a substantial cost to them. (for example, a few days ago I checked and the cost to insure against a decline in AAPL from the current price using puts was 7% of the nominal amount for only a 15 month period.) – Michael Sep 13 '16 at 22:23
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The difference is downside risk.

Your CD, assuming you are in the US and the CD is purchased from a deposit bank, will be FDIC insured, your $10,000 is definitely coming back to you. Your stock portfolio has no such guarantee and can lose money. Your potential upside is theoretically correlated to the risk that some or all of your money may not be returned to you.

  • This page from the FDIC seems to indicate that not all CDs are FDIC insured: fdic.gov/consumers/consumer/news/cnspr12/buyingacd.html – RoboKaren Sep 13 '16 at 15:36
  • @RoboKaren, Yep, if you buy a product from an entity that's not a deposit bank it doesn't carry deposit insurance. Edited for more specificity though. – quid Sep 13 '16 at 16:44
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    Between collapsing banks and inflation, money in a bank isn't as safe as one might expect. For example the euro lost about 20% relative to the US dollar within a year. – CodesInChaos Sep 13 '16 at 19:55
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    @CodesInChaos, not once in history has a single FDIC insured dollar been lost. The value of a currency will fluctuate regardless of the investment vehicle. – quid Sep 13 '16 at 20:00
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    @CodesInChaos That isn't really important to this question, though - that would only be relevant to this question if the euro lost 20% relative to the euro last year (which, that sort of thing absolutely does happen, being the definition of inflation, though generally not to that degree, which is why people talk about the "inflation risk" of leaving money in cash). Exchange rate risk doesn't really matter unless you're investing in foreign currency... you could make the argument that treasury bonds' prices fluctuate due to foreign investment if the dollar looks better, but that's not direct. – neminem Sep 14 '16 at 0:43
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Reliability

A CD is guaranteed to pay its return on maturation. So if you need a certain amount of money at a specific time in the future, the CD is a more reliable way of getting it. The stock market might give you more money or less. More is obviously OK. Less is not if you're planning to pay basic expenses with it, e.g. food, rent, etc.

Most retirement portfolios will have a mix of investments. Some securities (stocks and bonds), some guaranteed returns (CDs, treasuries), and some cash equivalents (money market, savings, and checking accounts). Cash equivalents are good for short term expenses and an emergency fund. Guaranteed returns are good for medium term expenses. Securities are good for the long term.

Once retired, the general system is to maintain enough cash equivalents for the next few months of expenses and emergencies. Then schedule CDs for the next few years so that you have a predictable amount. Finally, keep the bulk of your wealth in securities. As you get older, your potential emergencies increase and your need for savings decreases, so the mix shifts more and more to the cash equivalents and guaranteed returns and away from securities.

CDs have limited use prior to retirement (and the couple years right before retirement), mainly saving up for a large purchase like a house, car, or major appliance. Even there if you have the option of delaying the purchase, that might allow you to use securities instead. Perhaps some of your emergency fund in a short term CD that you keep rolling over.

Note that the problem isn't so much that securities will fall. It's that they'll fall right when you need the money. So rather than sell 1% of your securities to meet your needs, you have to sell 2%. That's a dead weight loss of 1% that you have to deduct from your returns. That roughly matches the drop from the height of 2007 to the trough of 2009 of the S&P 500. And it was 2012 before it recovered. If in 2007, you had put the 1% of your portfolio in a two-year CD, you'd be ahead even at zero interest in 2009.

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Growth and volatility are a matched set.

Growth is how well the investment will grow on average. In the long term, this is a sure thing.

Volatility is how much the value will jerk up and down in the short term.

Do you want both... Or neither? When are you going to use the money?

If it's IRA money you can't touch for 30 years, it really ought to be in the market, since growth is hugely important, and volatility is not a big concern. You're in it for the very long game, and volatility will average out, leaving pure growth. If the market drops 25% in 6 months, who cares? Stocks go up, stocks go down. It has 29 years to recover, and it will.

If you are planning to buy a house in 6 months, you want that money in something like a CD, because volatility could be devastating: an untimely 25% drop in stock price could really, really suck.

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    "Sure thing"? It might be expected but the Nikkei index is still below it's 1989 peak. – user662852 Sep 14 '16 at 12:23
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    @user662852 hey now, there's still 3 years to go – coburne Sep 14 '16 at 13:58
  • @user662852 and hardly the worst loser out there. Diversification, it is your friend... – Harper - Reinstate Monica Sep 19 '16 at 0:43
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For the specific example you gave, a CD with a 0.05% rate of return, I'd shop around some more, that's a VERY low rate of return. A more realistic one would be 0.5%, depending on the terms.

As has been mentioned, CDs are good when you need to preserve your capital. What might be a situation for that? They are great for Emergency funds, which you should always have a reasonable amount of cash in. I have a set up 3 CDs with 12 month terms, each carrying about 30% of my emergency savings. The remaining 10% I keep in a standard savings account, for quick access dealing with a short term emergency. The 3 are spaced about 4 months apart, so that I'm always within 4 months of having one come to term. They have a 3 month penalty if I withdraw early, but based on the fact that I have never had to touch more than 10% of my emergency savings, I'm perfectly okay with that.

What about more long term savings? Well, it depends on what your timeframe is for using the money. If it's more than 10 years, and you are willing to risk losing some of it, then by all means invest in a higher risk higher reward investment. If it's only a few years, maybe a bond fund is something that would be better. And if you really need to preserve the money, then a CD can be great too.

0

If you want to spend all of your money in the next few years, then a CD protects you from the risk of a bear market. however, if your time horizon is longer than 10 years, then the stock market is a better bet, since it is less effected by inflation risk. also, as you point out average stock returns are much higher, ignoring volatility.

On the whole, CD's appeal to people who would otherwise save their money in cash. generally, it seems these people are simply afraid of stocks and bonds because those securities can lose nominal value as well as real value. I suspect this is largely because these people don't understand inflation, nor the historical long-term index fund performance.

  • side note: my original answer suggested that people were merely ignorant of index fund performance. i did not mean to suggest it was a complicated concept. however, the OP edited my answer to better conform to his thoughts (or to hit the minimum edit requirement to better conform to his capitalization style). – james turner Sep 13 '16 at 21:55
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This all depends on your timeline and net worth.

If you're short on time before you plan to start spending it or have a large net worth, parking some of your money in CDs is a good idea.

If you have lots of time or not much net worth, then index funds are a better bet. Equity or dividend index funds are the way to go when you have 10+ years before you reach your goal.

CDs major downside is that they don't beat inflation 1 - 3% a year. This is why you only use them when it's absolutely critical you hold onto every penny of the principal. The reason is because with CDs your 10k is actually losing its value (not the principal) the longer you leave it in CDs.

I generally wouldn't recommend CDs unless you are in or approaching your 60s or have assets over 500k. Even still I would limit the use of CDs to no more than 20%. I would view them as catastrophic loss protection.

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