Savvy investors keep a portion of their portfolio in fixed-income investments where it's not subject to the ups and downs of the stock market. Many of these investors opt for the rock-solid security of certificates of deposit. But that can be a problem when CD rates are low for a prolonged period .
One way to beat rate cycles is to ladder CDs. It allows you to take advantage of interest rates spread over several maturities without sacrificing liquidity.
A ladder can be as long or as short as you like, but for this example let's use a five-year ladder with five rungs. If you had $20,000 to invest, you'd invest $4,000 in each rung. That is, you'd put $4,000 in a one-year CD, $4,000 in a two-year CD and continue up to $4,000 in a five-year CD.
After a year, the one-year CD occupying the first rung matures and each of the other CDs moves down a year. In other words, the two-year CD now matures in one year; the three-year is two years from maturity, etc.
The money from the one-year CD that has just matured is rolled over into the now vacant five-year rung. Every year you're replacing the rung that's farthest out -- in this case the five-year rung.
"The purpose of a CD ladder is to eliminate a lot of the emotional decision-making that goes on within an investment or savings plan while evening out the highs and lows that invariably come with interest rate cycles," says Jason Flurry, a Certified Financial Planner and president of Legacy Partners Financial Group in Woodstock, Ga.
By always replacing the longest maturity -- the top rung on the ladder -- you're always reaping the benefit of getting the highest rates. Also, by having a ladder, you're only reinvesting a portion of your investment when yields are low.
"That's when the ladder really pays dividends," says Bankrate.com senior financial analyst Greg McBride. "It balances out with previous years when you reinvest at a high rate of return. Over time the ladder smoothes out the peaks and valleys."
Probably the most important thing to keep in mind when laddering a portfolio of CDs is to make sure the maturities jibe with your cash needs. It's great rolling over CDs and their interest, but it's more important that your money is liquid when you need it. Penalties for early withdrawal will squash your returns.
While a five-year ladder will allow you to take advantage of the best interest rates offered, your ladder could be shorter if it makes you more comfortable. Likewise, the rungs should be whatever maturities suit your liquidity needs.
In an extremely low-rate environment, it's best to keep a new ladder short. You don't want to be stuck with low-rate CDs when rates start to rise.
By the same token, if you're a year or two into a more traditional five-year ladder and a prolonged low-rate environment develops, you can shorten your ladder as CDs mature. If the five-year rate is absurdly low -- less than the rate of inflation -- consider whether one-year rates may be a better deal. If that's the case then, as CDs mature, you may want to rebuild your ladder with three, six, nine, and 12-month CDs.
Try your hand at laddering CDs and see what your return will be with Bankrate.com's CD laddering calculator.