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CDs vs. a Diversified Portfolio

CDs vs. a Diversified Portfolio

May 03, 2024

My CDs are guaranteed!

By far, the most common question I’ve received in 2023 and 2024 is, “Why would I invest in stock when CDs are paying 5%?”  Since this question has been so common, I want to take the time to explain why “investing” in CDs isn’t a great long-term plan.  However, it’s not enough to simply understand the compelling math behind investing in a well-diversified stock portfolio.  In the last year, I’ve explained the “why” behind diversification dozens, if not hundreds of times and, frankly, it's persuaded very few people.  While it can be frustrating when people don’t listen to sound advice, it’s not surprising because investor behavior, not investment performance, is the real driving force when it comes to achieving financial goals.  As author Nick Murray says, “Investment performance doesn’t determine real-life returns; investor behavior does.”   Because Investor behavior is so unpredictable and, at times, irrational, it’s not enough to understand why a well-diversified stock portfolio is a better long-term strategy than tirelessly shopping CDs for an additional .1%.  We must also explain why investors may be predisposed to choose CDs rather than a well-diversified stock portfolio so that readers can identify when they’re being drawn into what I’ll call the “Safety Trap”. 


Facts are Stubborn Things


The Math

For the first time in a very long time, interest rates have risen to levels that make CDs look attractive.  But what about inflation?  As I’m writing this, prevailing 12-month CDs seem to be paying about 5% and the most recent Core CPI is 3.8%.  That means the real return on a 5% CD is currently 1.2%.  That means your purchasing power, after locking up your money for a year, has increased by 1.2%.  In case you’re thinking, “I can live with that, particularly if it’s risk-free.”  Remember, it’s not what you make, it’s what you keep.  CD interest is taxed as ordinary income.  What if your tax bracket is 20%?  Well, now your net real return is 1%.  To put that in perspective, if you invested $100,000 in a CD and you netted 1%, you locked up a lot of money for a year to make $1,000.  I know what many of you are thinking, “But it’s risk-free!” 


Risk-Free Just Isn’t a Thing

 Benjamin Franklin said it best when he said “death and taxes”.  I think he could have very easily added risk to his list of “unavoidables”.  After all, what indication do we have that inflation will stay at 3.5%?  In 1980, Core CPI hit 13.6%.  More recently, in 2022, core CPI was as high as 6.6%.  CDs have just never provided protection from the crippling effects of inflation.  The rebuttal I frequently hear from retirees is, “I won’t be around that long.”  Surprisingly, I hear this from 65-year-olds, 75-year-olds and 80-year-olds alike.  According to , a 65 year old in the U.S. has an average life expectancy of 19.66 years.  So, there is no reason to believe that the risks associated with higher inflation won’t apply.

The erosion of purchasing power coupled with long life expectancies isn’t the only risk to consider.  Expenses associated with long-term care needs are common and getting more expensive by the day.  According to Genworth’s Cost of Care Survey, the national average annual cost of home health aide was $75,504 per year; that’s 10% more than the previous year!  If we want to believe that we won’t have health issues or need help before we die, we’re just putting our heads in the sand; we can choose to ignore facts but many of us are going to live a long time and that will likely include some costly care.  An investor’s overall investment strategy should account for these likelihoods!


Understanding Investor Behavior

As I suggested above, investor behavior can often be erratic and, frankly, purely emotion driven.  Behavioral Finance is the fascinating study of behavior trends specific to investors.  The field of behavioral finance can give us some insights into why so many people are willing to choose a strategy that has returned much less than a well-diversified stock portfolio would.  One explanation is a bias called “Loss Aversion”.  Loss aversion is painfully common amongst investors, and leads people to avoid risk, even when the added risk is necessary to reach their stated goals. 

Loss aversion occurs when an investor is more concerned about the “sting” associated with a financial loss than the reward of a potential gain.  In plain English, researchers have found that people experience and remember discomfort, or pain of a loss, twice as much as they remember a win.  Loss aversion is one reason, people are still talking about 2008 even though the stock market has had positive returns almost every year for 16 years. 

I see this loss aversion bias play out as a practicing financial advisor. Clients frequently call me because they’re “losing money” while they’re literally making money.  Often, people will check their accounts at a moment when their account balance happens to be down, and their brain etches “I’m down!” in stone.  All the gains they made in the weeks prior to the slight downturn are not even considered, if they were noticed at all. 


There Are No Magic Beans

As investors, we all face innumerable risks:  Interest rate risk, longevity risk, inflationary risk, and sequence of return risk to name a few; but we pay way more attention to market risk because of our loss aversion bias.  So what’s an investor to do?  The first skill a successful investor must build is intentionality.  This entails thoughtfully crafting goals that are meaningful, identifying strategies that will help achieve those goals, understanding the costs, benefits, and risks of those strategies, and building a plan to achieve those goals.  The process of goal setting is critical to identifying the most appropriate investing strategies and, more importantly, helping investors make sure their behavior aligns with their overall goals.  Without a plan, we can find ourselves falling for the “safety trap” and losing money safely at the bank until it’s too late.