CDs = Bad Investment

Some time ago I wrote about how insurance is a bad investment and should be used only for protection.  Today I'm going to pile on another bad investment in the current financial environment - good 'ol certificates of deposit.

I’m routinely contacted by people looking for a higher rate of return than can be found on CDs. Such frustrated investors are everywhere these days, as 12-month CD rates have hovered below 1%. Even in this environment, however, many are reluctant to leave the ‘safety’ of CDs.

Here’s what I’ve told those investors, and everyone else for the past year: Safety and capital preservation are not the same thing. CDs are not safe, in terms of preserving your capital. They are in fact locking in a loss; the real CD return is currently negative after inflation plus taxes on the interest. If fact, in terms of annual purchasing power, a CD investor will likely have about 2% less than they did before putting the money in the CD.

To preserve capital in this market/economy, investors will need something more than CDs. One secure alternative is U.S. government bonds. The interest paid may not be much more than on CDs, but those bondholders don’t have to pay any state taxes on the interest. These bonds do carry risk, but in a way, U.S. government bonds are safer than CDs – there’s less chance Uncle Sam will go insolvent than a bank.

Another alternative is municipal bonds. For residents who purchase such bonds issued in their state, none of the interest is taxable at the federal or state level. This means a bond with a 2% coupon would have an effective taxable yield of closer to 3%, assuming the bond is purchased at or near par value.

A third option is to invest in dividend paying stocks of large companies. Many well-known companies are paying up to 5% a year just to invest in their stock. The stock price could go down, but if it goes nowhere the investor will make that dividend yield on the money, and if the stock price goes up, even better! And also, qualified dividends currently receive favorable tax treatment.

These are all good, manageable risks for people to take with some of their savings – and it beats the heck out of an inflation-and-tax adjusted 2% loss!