It was only a few years ago I'd have clients bemoaning their CD rates which were "only" 5% and how they remember bank rates north of 10%. And now, looking at Yahoo Finance, I see that the national average for a one year CD rate is 0.64%. But before you get too excited, let's figure out what it would be after taxes. Assuming you're in the 25% tax bracket you're going to need to fork over 0.16% of that to Uncle Sam and you walk away with 0.48%. But, there's more... in 2011 the national inflation rate was 3%. I often call inflation the "invisible risk" because we all get tied up in the number of our money (as in let's say you have an account worth $100,000) when it is purchasing power that is the practical definition of money. So, while you may have earned 0.48% after taxes on your $100,000 CD, although your balance shows $100,480 (I'm ignoring compounding for now, it wouldn't make a dramatic difference), effectively this money is only worth $97,480 in purchasing power when you bought it one year ago. By buying the CD, you've locked in a 2.52% loss. And for those wondering, US Treasury bonds are paying less than half this yield (it's normal for US Treasuries to pay less than CDs).
To me, this is sad. Particularly because by experience I know that many retirees had saved up money, possibly in stocks and had planned that when they would retire they would switch it all to CDs and live off the 5% interest. The idea being, change it from "risky" investments to "risk-less" investments. I'm putting it in quotes for a reason and you'll see why.
All investments have a risk, but often the biggest risk is not principle fluctuation (or price volatility as with stocks). We all hear of the adage "buy and hold", statistics show that most investors don't do this. A majority panic out of the market - in other words, the market goes down and they sell out of their stocks or mutual funds and put it in cash until it settles out. But what happens? The stock market dives down, pushes off the bottom of the swimming pool and comes back for air. Right now the stock market is only 10% or so from its peak valuation in October 2007 (and by the way this is ignoring nearly five years of dividends which are currently above 2% on the S&P 500).
You may see where I'm getting at... 2% dividends over five years adds up to 10%... from a price standpoint, if the market is down about 10% off its peak, someone who had the absolute worst luck in the world and bought in on the peak day of the market and simply rode it out would now be back to where they started. Actually they'd be above where they started if those dividends reinvested in stock prices much lower than where they started. Of course most people would not be particularly pleased about breaking even over a five-year period, but considering the financial crisis that we went through and the most hostile economic environment since the Great Depression and especially considering that very few people went in right at the peak of the market, well things are not as bad as some may guess.
The moral of the story is that, while past performance does not guarantee future results, by a simple observation of history it can be observed that all past market declines have been eventually erased (and the current one is only 10% away from being erased).
To me, the unspoken goal of all people saving money or investing money is that they want to grow in their power to purchase goods. Over time, principle fluctuation is not a risk if you stay invested. If you have a short investing time frame (such as less than five years) and you plan to withdraw it, then price fluctuation could be a problem. However, the "risk" of price fluctuation and market volatility diminishes with time. If you want to decrease your risk of losing money in the stock market, simply stay in there longer. Is this not what we learned in the past five years? If you could go back in time and advise a friend who is worried about how much their portfolio is down, what would you tell them? You'd tell them to hang in there.
Going back to CDs, the flip side of this is dire. Historically speaking, after taxes and inflation CD owners rarely break even (as a measurement of their purchasing power). This was even true in the days of 10% CDs; it was in the context of double-digit inflation. If you have a 10% CD and Uncle Sam took 25% (we'll ignore for a second that taxes were higher then) you end up with 7.5%... take out 10% inflation and your ability to purchase goods went down by 2.5%. That 10% CD isn't as exciting all things considered. As far as risk is concerned, this situation is just the reverse of stocks. In the short term, losing 2.5% in purchasing power will be virtually unnoticeable in the first few years.
However, let's say that someone from the early 80s stuck with their CDs and annually locked in that annual -2.5% loss. Over time this would add up to more than a 50% permanent loss of purchasing power (meaning it's not a temporary fluctuation like the stock market). Historically speaking, inflation rarely, ahem very rarely reverses its course. All the while they probably felt completely safe and secure in CDs as they watch their "number" go up (as in the principle). But again, focusing on the principle number is the wrong thing to focus on. Over a long period of time, inflation is VERY risky as it's the one headwind that ceaselessly blows against you. The only way to beat it is to be in investments that typically outpace inflation and minimize ones that don't do this. It's that simple.
In this piece for simplicity's sake I've contrasted stocks and CDs, but naturally there are many other things out there and methods of diversification. The other half of this is having a solid financial plan that helps you ride out price fluctuation. Studies have shown simply having a written financial plan helps you do this. Earlier I talked about going back in time and giving investing advice to one of your worried friends or even to yourself, I see a financial plan as something that helps your future self, talk to your present self.
I believe our future selves would tell us to not worry about the stock market fluctuation that it is not a problem over time, but what is a problem is that the cost of living has risen every year. A good financial plan reiterates your long-term objectives, or if the plan says that your objectives are short-term then it may tell you that inflation may be less of a risk for your plans. However, in my experience, inflation is always the biggest and surest risk affecting a person's financial goals in the long term.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.