How to choose whether to invest in CDs or stocks

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Many factors weigh into whether it’s best to invest in stocks or CDs. But ultimately it comes down to your personal financial situation, time horizon and risk tolerance. If you’re trying to choose between one or the other, it’s important to take a close look at each financial tool and match it with your goals.

Who CDs are good for

“CDs can provide stability to an investment portfolio, as well as be a source of funds for near-term expenses,” says Juli Erhart-Graves, certified financial planner and president of Worley Erhart-Graves Financial Advisors in Indianapolis.

While stocks fluctuate in value, CDs pay a fixed rate on a fixed term. They’re a low-risk investment.

That can make them ideal for those will large expenses on the horizon.

For example, if you plan to replace your vehicle in a year and know you’ll need $20,000, parking it in a CD for that period of time could be a good option, Erhart-Graves says.

By investing in a CD, you won’t lose any principal from that $20,000, but you’ll still earn some interest. As long as you choose a CD term that lines up with when you need to buy the new vehicle, the money will be there when you need it.

CDs can also be used for general liquidity. Short-term CDs, for instance, can serve as a place to keep cash and earn a higher interest rate without locking up your money for a long time, Erhart-Graves says.

Conservative investors, or those who may lose sleep at night when they experience losses in investment accounts, may find the low-risk nature of CDs an attractive option as well.

What to expect when investing in CDs

You can expect a CD to hold its value, pay interest on a set schedule and provide your principal back when the CD matures.

That’s assuming you don’t withdraw any of the money before the CD matures. Early withdrawal fees from banks can eat up all of your interest and even some of your principal.

In terms of safety, CDs are generally insured by the FDIC, or Federal Deposit Insurance Corp., up to $250,000 per account. But not all CDs come with that protection. And although defaults are rare on CDs, it’s important to make a conscious decision about how important FDIC insurance is to you. An insured CD will pay a lower interest rate than a non-insured CD, Erhart-Graves says.

While CDs do carry a level of short-term safety you won’t find with stocks, a downside is that CDs may not keep up with inflation.

“Investing most of your money in CDs means you will likely lose purchasing power over time,” Erhart-Graves says. “Therefore, even conservative investors need to consider investing in other types of investments, like stocks and bonds, to keep up with and beat inflation.”

CD rates languished at historical lows after the 2008 financial crisis. In fact, in January 2014 the average 1-year CD yield hit a low of 0.23 percent. Fortunately, CD rates have been on the rise lately. You can now find institutions offering CD rates 10 times that average or more.

Who stocks are good for

“Stocks are best for investors seeking long-term growth who are willing to ride the ups and downs to get there,” Erhart-Graves says.

But how much you allocate to stocks in your portfolio depends on your risk tolerance, time horizon and financial goals.

“We all want maximum growth from our investments, but we can’t all stomach the down markets,” Erhart-Graves says. It’s a matter of finding the right balance of stock exposure, so you can handle staying invested in the good times and the bad.

When it comes to time frame, stocks are a marathon, not a sprint. If you need money back within a short time period, you shouldn’t invest in stocks, Erhart-Graves says. There’s no standard definition of “short term,” but she says she wouldn’t invest in stocks if she needed the money within five years.

Notably, you don’t have to be an aggressive investor to invest in stocks. Even conservative investors can have some exposure to the stock market, Erhart-Graves says.

Likewise, aggressive investors need to have some conservative investments as well, like cash, CDs and bonds, she says.

What to expect when investing in stocks

When investing in stocks, expect to see some fluctuation. And keep in mind that a down market can last a year or two.

But also expect to pay more attention to stocks than you would CDs — you’ll need to monitor your investments.

If you’re investing in individual stocks, you should know things like the price that you want to buy and sell the stock, Erhart-Graves says. You should also keep current on any company changes that would alter your outlook on that investment.

If you’re investing in stock mutual funds, she says, it’s important to keep up with things like manager switches, fee changes and how the fund is investing.

CD vs. stock returns

History shows that over the long-term, stocks will substantially outperform CDs, Erhart-Graves says.

But she notes that from time to time, CDs can return more than stocks during flat or negative stock markets.

The bottom line

Both CDs and stocks have a place in an investment portfolio. If you’re interested in a low-risk investment that provides safety for upcoming expenses, or you simply want to stay conservative, a CD can be a great option.

On the other hand, if you’re looking for a long-term investment that will have some ups and downs but ultimately earn a better return, stocks may be a better option for you.