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CDs have the potential to offer a risk-free return. But are they better than stocks? Read on to find out.
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The problem with investing your money is that you run the risk of losing some of it. Even if you buy shares of a strong company that’s been in business for a long time, there’s no guarantee that those shares won’t lose value at some point, either because the company experiences a negative event or the stock market declines on a whole.
That’s why you may prefer to put your money into a safer vehicle. And a certificate of deposit, or CD, might fit that bill.
With a CD, you lock in a certain rate on your money for the duration of your CD’s term. If you open a 12-month CD at 4%, for example, you’re guaranteed to get 4% back on your savings during that time. And also, as long as your total deposits per bank don’t exceed $250,000, your principal is protected as long as your bank is FDIC insured.
To put it another way, you might buy $1,000 worth of a given stock only for those shares’ value to drop to $800 in a few months. If you open a $1,000, 12-month CD at an FDIC-insured bank paying 4% interest, no matter what market conditions look like, you’re going to get your $1,000 back once your CD comes due. And as long as you don’t cash out your CD early, you’ll earn $40 in interest during those 12 months.
But while CDs carry a lot less risk than stocks, they’re not necessarily the best long-term investment for you. Here’s why.
When you want a higher return on your money
CDs are paying fairly generously these days in the wake of recent Federal Reserve interest rate hikes. But there’s no guarantee that you’ll be able to snag a risk-free 4% on your money in a few years from now. By then, it may be that CD rates have dropped down to 2%, or 1.5%, earning you very little.
On the other hand, over the past 50 years, the stock market has delivered an average annual 10% return before inflation, as measured by the S&P 500 index. And while that 10% isn’t guaranteed, even if your portfolio delivers a slightly lower return, you might earn more on your money than what a CD will pay you.
In fact, let’s say you invest $1,000 today and leave that money alone for the next 40 years. Let’s also assume that you’re able to earn an average annual 8% return on your $1,000, which is a little bit below the stock market’s average. That would leave you with a little more than $21,700.
By contrast, let’s say you put that $1,000 into a CD over the next 40 years, and your average annual return there is 2%. That would leave you with just $2,200.
Taking on some risk could work to your benefit
Stocks are a riskier investment than CDs — there’s no getting around that. But if you invest in stocks over a long time frame, you can mitigate some of that risk by giving yourself time to ride out stock market downturns.
And if you’re not convinced that stocks are the better choice, take it from financial guru Suze Orman. In her blog, Orman said, “CDs are not some magical solution for all your money. To have the best shot at earning long-term inflation-beating gains, you need to be invested in the stock market.”
Orman knows full well that the CD rates we’re seeing today are more of an exception than the norm. And she also knows that sticking to CDs over time could leave you short on savings when milestones like retirement arrive.
This isn’t to say that you shouldn’t put any of your money into CDs. But for the most part, it’s best to put the bulk of your long-term savings into stocks so you can generate a higher return that’s more likely to help you meet your goals.
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