A certificate of deposit (CD) is probably the surest return you can find in the investment world. A CD provides you a guaranteed return over a certain time period, and it’s backed by the bank that wrote it and the U.S. government behind that. It’s about as rock solid as an investment gets.
Because of this bedrock safety, the CD allows you to take a bit more risk with the rest of your portfolio, especially the parts that you don’t need to access immediately. That’s why you should consider the value of CDs as part of your overall portfolio and what they allow you to achieve.
How a CD works and why it’s valuable
Let’s run through the basics on a CD to understand why it can form the foundation of a solid investment portfolio.
A CD is an agreement between you and a bank or other financial institution saying that you agree to deposit your money there for a specified time. In exchange, the bank agrees to pay you interest over that time.
It can be a solid trade: the bank gets the security of having funds at its institution, while you get paid higher interest to keep your money at the bank than you would from other bank accounts. In fact, a CD typically pays a fair bit more interest than a typical savings or checking account.
The downside is that you don’t have ready access to your money until the CD matures, at least not without paying a penalty. If you do need the money immediately, the bank will charge you a penalty for early withdrawal. The bank wants to be sure that it has access to your money, so it gives you an incentive not to break your agreement before the term of the CD is complete.
While most CDs operate like the example above, banks have become more innovative and now offer a variety of CD types to meet savers’ needs. Some CDs allow you to take out your deposit without an early penalty, though you’ll usually earn lower interest. Others allow you to step up your interest rate during the CD term. (Here’s how to find the right CD for you.)
Here’s how a CD can be valuable for you: you’re guaranteed the stated return that you agreed to with the bank. You won’t lose principal, so there’s no risk, and you’ll get every penny coming to you. This kind of 100 percent safe, reliable return is the cornerstone of an investment portfolio, and it ensures that you have money coming in regardless of how stocks and bonds fluctuate.
So while the markets may be volatile on occasion, your CDs won’t budge and will keep earning interest day after day. But this perfect safety from CDs also allows you the ability to take a little more risk with the rest of your portfolio, helping you achieve higher long-term gains.
[COMPARE: Bankrate’s list of top CD rates]
Fitting CDs into your overall portfolio
To take advantage of the strength of CDs, you’ll want to think of all your investments as a giant portfolio. In this portfolio, each type of investment provides a different type of return and risk.
There are three broad asset categories here:
|Bank products (CDs, savings accounts and others)||Very low||Low|
Bonds function similarly to CDs in that they pay a regular return over time. However, they’re not as low risk, and investors could lose principal when purchasing them (unless they’re government bonds held until maturity). Bonds tend to offer a higher return than CDs, because they’re riskier. But their price can go up and down more, based on interest rates. When interest rates rise, bond prices fall, and vice versa. A diversified group of bonds might yield somewhere around 4 percent.
Stocks can offer a higher return, but you’ll often have to ride through a lot more volatility – so it’s good to have the steady performance of CDs to keep you balanced. Historically, a diversified portfolio of stocks has earned about 10 percent annually, but stocks will usually go up and down much more than this number in any one year. Like bonds, the trade-off with stocks is higher return in exchange for higher risk. Sometimes the risk can be very high, but so can the returns!
However, by anchoring your portfolio in CDs, you can add a little bit more risk and attempt to increase your overall return without becoming too risky. If you’re very heavily weighted in CDs, you can trade a little bit of safety for a little bit of return.
How diversification works by the numbers
So how does this look in practice and what would you do to set up such a portfolio? The more of your portfolio that you have in CDs, the flatter the overall return, but also the safer. On the other hand, the more stocks make up your holdings, the more the overall return will fluctuate. So you’ll want to carefully consider how much extra risk to take on and when you’ll need your money.
One popular way to invest in CDs is through the use of a CD ladder. It’s an investment strategy where you invest a portion of your money for a staggered set of time periods (say, one year, two years, three years). This approach minimizes the impact of fluctuating interest rates and gives you better access to your money. Other investors prefer to buy the longest, highest-yield CD, while still other investors use a barbell strategy to provide ready cash.
Once you’ve organized the CD portion of your portfolio, you’ll want to think about how you’ll select bonds and stocks. When buying these, many investors purchase mutual funds or ETFs, because they’re highly diversified, meaning your returns won’t fluctuate as much as by owning individual bonds and stocks. Investors often stick with a big index fund as the Standard & Poor’s 500 Index, which consists of hundreds of large American companies.
Here’s how a blended portfolio with stocks, bonds and CDs could generate returns over a 10-year period, assuming various proportions of stocks and bonds.
This graphic shows you how your overall return could rise through modest increases in higher-return assets such as stocks and bonds, while keeping core CDs to anchor the portfolio. So here your CDs allow you to take slightly higher risks in order to get a better total return.
What this chart doesn’t show you, however, is some of the month-to-month fluctuation that comes with having stocks and bonds in a portfolio. But with relatively small proportions of these higher-risk assets, the overall fluctuations should not be too severe.
CDs can form the heart of a good investment portfolio, ensuring that you have regular cash flowing into your portfolio regardless of what’s happening in the larger investing world. And you can transform that security into a strength by adding some higher-risk, high-return investments such as stocks and bonds into the mix. You’ll get the benefits of diversification and probably be able to enjoy a higher return over time, too.
- Here’s how you can use CDs to protect against a falling stock market
- 4 ways to get better returns than CDs
- Calculate your potential earnings on Bankrate’s CD calculator