Investors choose CDs in large part because of their safety. An FDIC-insured deposit at a bank, or a NCUSIF-insured deposit at a credit union, regardless of the bank's Safe&Sound or CAEL rating, have no risk of the investor losing principal.
But there's more to investing than just protecting principal. When a person invests, he should expect to earn a positive, real return on his investment. A real return is yield that outpaces future inflation.
Inflation impacts CD rates
Inflation, as measured by the consumer price index, or CPI, hasn't been all that onerous, with last week's release of August CPI showing just a 0.01 percent inflation rate for the month. Over the last 12 months, the rate was just 1.5 percent. Pretty impressive when oil is more than $100 per barrel. The CPI also reported less food and energy. That measure is called core CPI, and by that measure, inflation increased by 1.8 percent for the last 12 months ending August 2013. While it's true investors are impacted by future inflation rates and not historical rates, there are not a lot of signs that future inflationary pressures are mounting.
The point is, with the Federal Reserve following a monetary policy that keeps short-term interest rates low, even with inflation rates below 2 percent, it's next to impossible for CD investors to earn a positive real return, especially on an after-tax basis.
The Fed has actually been trying to push investors into riskier investments by keeping short-term interest rates so low. Stocks with high dividend yields have been a popular choice for yield-starved investors, and with the stock market up over 20 percent year-to-date through Sept. 17 on a total-return basis, the dividend yield investors by and large haven't seen their total returns suffer from falling stock prices.
Handy hint for investors
So what's the point of this blog post? People putting money to work in CDs need to differentiate between savings, where protecting principal is paramount, and investing, where increase purchasing power is the goal. They need to avoid over-allocating money to savings that should be invested. If you earn a positive real return then, by definition, you haven't lost principal. Unfortunately, risky investments can't guarantee that you'll earn a positive real return.
Where to invest? You still need to consider your ability to take on risk to principal, what you're comfortable investing in over time, what financial or life goal you're investing toward, and your investment horizon.
Are you saving or investing? Where are you putting money to work with the expectation of earning a positive real return?
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Don Taylor is Bankrate's Personal Finance Adviser and an assistant professor of business administration at Penn State Brandywine in Media, Pa. He holds a doctorate in finance and has earned both master's and bachelor's degrees in finance. To ask a question of Dr. Don, go to the "Ask the Experts" page and select select one of these topics: "Financing a home," "Saving & Investing" or "Money."