The stock market’s been quite frothy of late, and if you’re heavily invested in stocks, it’s a good time to remember that stocks don’t move up in a straight line, despite their solid run after the financial crisis. Eventually the market will hit a bump and go tumbling.
Stocks have been riding high for years, but it’s not totally clear how much longer the economy can continue to expand. While some argue that a recession is imminent, others say we’re still years off. But few believe there are that many years of expansion left.
And if growth does end up slowing, expect stocks to fall and interest rates to plummet alongside them.
However, there’s another option available for your savings that can provide guaranteed returns and diversify your risk away from the volatility of stocks — it’s the certificate of deposit, or CD.
When you set up a CD, you’re making an agreement with the bank to lend it money for a specific time. In exchange, the bank pays you an agreed-upon interest rate over the term of the CD. CDs come in a variety of maturities, from just a few months to many years.
Using CDs to protect your portfolio
The biggest value of CDs for savers and investors is that they lock in a cash yield for a set time period. Regardless of what happens to the market, those CDs will keep plugging away paying interest. This kind of safety can be a relief – a rock in the storm – when stocks are plummeting.
This means that CDs will allow you to take advantage of the power of diversification to help your portfolio. While CDs offer returns that are well below what the stock market has returned on average – about 10 percent annually over long stretches – the returns on CDs are not volatile. You know exactly what you’re going to get from the start, and that safety helps even out your portfolio’s returns.
For example, let’s imagine $10,000 being invested over a 20-year period from the start of 1999.
Here’s how this money would grow in three different scenarios:
- invested completely in the S&P 500 index of large stocks
- 75 percent stocks and 25 percent in CDs yielding 2.5 percent
- 50/50 split between the two
CDs offer lower returns over time than stocks, reducing a portfolio’s overall returns. But at any individual moment, CDs may be generating more because stocks are so volatile. So CDs (and other fixed income assets, such as bonds) work to smoothen a portfolio’s returns over time.
You can see that in the graphic above, where the portfolios with CDs perform better than an all-stock portfolio when stocks are faring poorly and worse when stocks do well. The 50/50 mix, for example, is smoother – it hits higher lows and lower highs than the all-stock portfolio.
Also note that rates tend to fall during recessionary periods at the same time stocks may be falling. So if you wait until stocks fall to lock in your CD rates, you might have to endure losses on your stocks and get lower interest payments on top of it. Investors have to anticipate the changing market conditions and then take action.
One approach for buying CDs is to dump all your money into the highest yield at the time – typically the longest duration – but the downside is that you could tie up your money for years. But this approach is too simplistic. You may need the cash before then or want to invest some of that money in stocks when they fall, and be forced to pay a penalty for early withdrawal. Whatever the reason, it’s useful to have some cash on hand or in the near future.
Build a CD ladder
One way around this difficulty is to use a CD ladder, which allows you to have cash at the ready but also enjoy the benefits of CDs.
“Most investors focus on the CD yield. But what might be more important is how you structure your CDs,” says Megan Gorman, managing partner at Chequers Financial Management.
“For instance, you may structure your ladder so that a CD matures every six months,” she says. “That would mean in the portfolio, you may have a six-month, 12-month, 18-month and so on. You will get a blended yield, but you have provided options for yourself over the long term.”
When the six-month CD matures, you can roll that over to a new 24-month CD at the top of the ladder or you can move the cash to where you need it or into stocks, for example.
The laddering approach helps ensure that you have cash when you need it, but it does come at a cost. You won’t earn as much as you otherwise could have by owning a longer CD.
“Don’t forget about FDIC risk,” says Gorman. “Investors can also look to ladder their CDs across a number of banks” in order to eliminate going over the maximum amount (currently $250,000 for each account type) at each bank that is insured by the FDIC.
How to get started using a CD strategy
The first step to implementing this type of CD strategy is to survey the landscape and find out what the options are. Your primary bank may offer poor CD rates or may not always offer the best rates for a specific CD maturity.
“Many people just simply deposit their cash in their checking account or set up their savings accounts with the bank that manages their checking account, but there are usually various better options out there,” says Philipp von Girsewald, CEO US at Deposit Solutions, a fintech company that sources funding for banks from non-traditional sources.
So it’s vital to shop around on rates, and one of the easiest places to begin is on Bankrate’s review of best CD rates, which lists hundreds of CDs available across dozens of banks. You’ll be able to search by maturity, so you find the best return for each rung of your CD ladder.
You’ll also want to consider how much of your portfolio you move to CDs in order to mitigate the effects of a down market. On the one hand, you may regret keeping most or all of your assets in stocks if the market enters a prolonged downturn. But on the other hand, having all your assets in CDs can mean years of low returns, and you may miss any gains when stocks do rise.
So a happy medium may be the answer. You can move some amount of cash to CDs – 20, 40, 60 percent as an example – that lessens your reliance on the stock market but still gives you some exposure. But you’ll need to determine what amount works best for your situation and when you’ll need the money that you’d be tying up in CDs.
One way to mitigate the dilemma of locking up your money in CDs is what’s called a “no-penalty CD.” A no-penalty CD allows you to take your money out of the bank without incurring what can be a sizable fee for early withdrawal, often 90 days’ or 180 days’ worth of interest.
The extra convenience of a no-penalty CD can cost you in the form of lower rates, but if you need access to the money (or might), it can be worth avoiding the hefty penalty. Otherwise, if you need ready access to your cash, your next best option is a high-yield savings account.
Using CDs to lessen your exposure to the stock market is a time-tested way to diversify away from riskier assets toward safer ones. While the potential downside is lower long-term returns, the benefit is a smoother set of returns because your portfolio has less volatility. With economic growth looking a bit less certain in the near future, it might be a good time to lock in relatively high CD rates while they’re still available.
This story was originally published on Bankrate. Create an account on Bankrate today to get your free credit report along with expert advice to improve your score. Plus, set your financial goals to personalize your dashboard with resources to help you reach them.