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The risk of leaving too much money in CDs

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Are you investing to not lose money rather than to earn it — staying in the slow lane, sticking with certificates of deposit, inching your way to modest returns?

“Being too conservative, or driving too slowly, can be as risky as driving too fast,” says Wade Slome, president and founder of Sidoxia Capital Management LLC in Newport Beach, California.

What if CDs drive your investment income? There might be better investment choices than CDs, especially these days with CD yields stuck in low gear. Your nest egg could run out of gas before your retirement ends.

Diversifying your investments with stocks, bonds, real estate, commodities, alternative vehicles and emerging markets could grow your money faster, and you won’t have to ditch the safety of CDs.

CDs are kind of in the same range as AA corporates or junk munis,” says Joel Larsen, principal at Navion Financial Advisors in Davis, California. “There is very little risk, and if you’re going to take very little risk, you’re going to get very little return.”

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Total asset allocation

No one is suggesting that you immediately yank your money out of CDs and start snapping up hedge funds.

“What you really need to do is back up completely and look at the whole asset allocation,” says Jennifer Lane, CFP with Compass Planning Associates in Boston.

Keeping a portion of your assets in CDs as part of an emergency fund might be a wise choice, Lane says. Once you have that emergency cash stash in place, you can think about easing into the stock market with what Lane calls “plain vanilla” index funds. A good mix might be a large-cap index like an S&P 500, some mid-cap, some small-cap and a little bit of international,” she says.

Larsen says even the most conservative investors among his clients have no more than about half of their money in fixed-income investments like CDs. For that group, he recommends a mix that balances fixed-income investments with dividend-producing instruments like stocks and real estate investment trusts, or REITs.

Lane cautions against jumping into indexed annuities and other complex investments in the chase for higher rates. Before you leap, ask an independent adviser plenty of questions so that you understand what you’re getting into.

“CDs are very straightforward and simple,” Lane says. “If you are going to move away from them, educating yourself about what you’re investing in is very important.”

Ladders and barbells

Laddering is a popular technique among investors trying to get the best yield out of a CD portfolio while maintaining a certain level of liquidity. Here’s how it works: You spread your investment equally into CDs of varying maturities (one year, two years, five years). Each type represents a rung on the ladder. When your shortest-term CD matures, you reinvest the money into a five-year CD. Laddering provides more liquidity than locking up all your money in long-term CDs at once.

But these days, with even long-term CDs yielding extremely low returns, your savings aren’t likely to climb much, no matter how you adjust your ladder.

“You can try to be creative and do different laddering approaches with CDs, but when you’re earning next to nothing, it’s difficult to squeeze water out of the rock,” Sidoxia’s Slome says.

Some investors might want to consider whether using a barbell strategy — putting half your portfolio into short-term, fixed-income securities and the other half into long-term securities — would be useful in this low-rate climate. Applying this strategy to CDs, you might roll short-term instruments into high-yield bank accounts as they mature, with an eye toward converting your barbell into a CD ladder once long-term rates start climbing again.

For Slome, a more important issue is how your strategy impacts the duration of the CDs or bonds you invest in. Duration, the number of years it takes for an investor to recover the true cost of a fixed-income security, reflects how the value of that instrument changes as a result of a change in interest rates.

“There’s nothing wrong with using a barbell strategy, but it’s not a silver bullet,” Slome says. “What’s more important is the interest rate sensitivity you create.”

Inflation trap

A so-called “safe” investment such as a CD may protect the value of your money from market risk but not from the purchasing-power risk of inflation.

“Over time, your fixed-income portfolio is guaranteed to lose money to inflation,” Navion’s Larsen says. “If it’s an IRA, where there are no taxes, and you’re yielding 4 percent, and inflation is 2 percent, you’re only getting 2 percent return on your money. And that’s if you’re not spending it, and most people are.”

Investors’ risk tolerance differs, depending on their retirement time horizon, their need for liquidity, estate planning concerns and a host of other factors. Your investment plan should certainly be designed to fit your personal risk-tolerance level.

But unless you can afford to invest millions of dollars in CDs, relying on them alone for your retirement fund is not a winning strategy.

“For most people who aren’t in the 1 percent, the best prescription is to create a globally diversified portfolio across various asset classes, such as stocks, bonds, real estate, commodities, alternative investments and emerging markets,” Slome says.