Investing in a rising interest rate environment – Part 2: Certificates of Deposit.
The internet and self help books seem to spend a lot of time these days telling us how fear is bad for us. It also seems to preach that we should do everything in our power to overcome it in order to live our most optimal life. This argument seems to completely ignore the fact that fear can actually be a good thing since it is our bodies natural defense mechanism. It can also serve to stop us doing things that might be detrimental to our health or well-being. The instances where fear can be bad for us is when it becomes overwhelming and debilitating or is irrationally based. However we should never view all fear as irrational always. We should spend time to reason and understand it’s basis, then choose whether to dismiss it or use it positively to influence our decisions.
The investing world also tends to view fear as toxic, the rationale being that fear stops us from taking the bull by the horns and getting our best returns. Or that it is responsible for market crashes as investors head for the exits gripped by it. We have seen both sides of this argument played out, people debilitated by fear such that they sit permanently in cash assuming this approach carries zero risk versus the risk taking yield chaser who get’s burned by that too good to be true return. Neither of the above is obviously optimal but we feel a reasoned approach somewhere in the middle helps us to live a balanced and happy life without stress eating away at our minds too much. We are not letting fear control us, simply placating that part of our consciousness that craves security.
CD’s or Certificates of Deposit are viewed in the stock investing world as low risk, fearful investments for people who are scared to invest in the markets or do the research to figure them out. They are deemed the no-brain investment. This is not necessarily the case though and is a little unfair. We would argue that they can act as a perfectly acceptable compliment to a well balanced stock portfolio in order to stop us getting too far ahead of ourselves and putting too much risk on the table. They can also act to give us our much needed income source diversification in financial independence and retirement, nothing to be ashamed of. This does not mean that we are 100% invested in them as that level of security is not necessary for us, we are willing to take some risk to enhance our returns but we need to balance out our risk.
CD’s come in a few different forms, however we only use the investments offered by the high street or internet banks and 10 year Money Market non-callable brokered CD’s. Neither of these should necessarily be perceived as bad investments when used in the context of larger portfolios. In fact the latter has served us well in the past as a proxy for government bonds. They have generally offered us a better yield more than a full percentage point above the 10 year Treasury while still offering the equivalent FDIC protection. In our experience they have acted very similarly to bonds too, when the market has a good day this investment will sit in the red and when the market goes into free fall they will tend to sit in the green as a safe haven.
The difference being that they are bought and traded through a brokerage rather than bought directly through the bank. When we invest we tend to build up a 10 year ladder with each year represented by $1000-5000 invested with maturity dates from, say 2020 through 2029. So when 2020 rolls around, assuming the rates have continued to rise per current trends we should be able to switch out to a higher rate for another 10 year cycle on maturity date when our initial investment is returned to us. Each CD then proceeds to pays us income once every 6 months to our brokerage account with our regular dividends.
Over the last couple of years in the lower rate environment we have still been able to lock down an average rate of 2.25-2.5% which is comparable to a lot of our perceived low risk dividend stocks that we hold in the portfolio, just without the tax advantage. They were simply bought through searches from within our brokerage account. In the future we expect the value of the CD’s to decrease as higher yield versions become available further towards maturation. However we believe if we stick to our ladder process and just accept the limitations then this investment serves to satisfy the part of brain that craves security and wants to sleep well at night. All the while the stock investor side of our brain scoffs at us for wasting income opportunity when it could be joining the rest of the portfolio getting 4-12% yields.
That said we can easily quieten the stock investor side of our brains by showing this as a dry powder fund such that in the event of a market collapse we can go bargain hunting.
We also find regular internet bank issued non-brokerage online FDIC insured CD’s through websites such as Bankrate.com for the same reason. They are used as an investment vehicle in which to hold our rainy day fund in 5 year ladders, providing us with a steady safe income from our backup funds. In much the same way we will turn them over every year to the new hopefully higher interest rate or take the option to withdraw the monthly interest gain if we ever need it.
Ultimately investments such as CD’s are a matter of personal choice and we are of the belief that a little fear does nobody any harm. It is about finding ways to balance and placate your fears to invest in way that means you have minimal stress on a day to day basis and your investments are sufficiently balanced to not become too overwhelming. We are basically taking some of our funds and sacrificing returns for security. CD’s can and do aid in providing balance in this sleep well at night process.
As the Federal Reserve continues to increase interest rates the best strategy we have found is to set up a 5 or 10 year CD ladder so that expiry dates happen every year and we can continuously transition to the higher rates as they occur. The hope being that in a rising inflation environment the subsequent interest rate rises will keep us ahead.
Thanks for reading,