Can You Really Afford a Guarantee--Part One

Market volatility.  The Dow fluctuating over 4% in one day.  Enough to make investors near retirement cringe and lose sleep and even younger investors with many years left before touching the investment still become apprehensive.  Continuous news reports of impending disaster in Europe and maybe a double dip in the United States.  Recent history reveals a flat market over the last 10 years or so.

Seemingly good reasons to sit out of the investment game. Despite historically low returns on CDs and FDIC insured deposits, some investors have pulled their money out of anything touching stocks and bonds and are sitting in the sidelines.  But is this the right move?

Of course, investing is an individual one-on one process and strategies vary depending on age, risk tolerance and many other factors and this analysis is not meant to give investment advice but to examine a couple of misconceptions about supposedly “safe” investments.

FDIC (federal Deposit Insurance Commission) which was created in 1934, covers up to $250,000 for one owner at an insured bank for CDs and checking accounts.  For joint accounts, the total coverage amounts are higher.

First let’s look at historical data—while no guarantee of future performance, we can at least establish what has happened in the past.  Let’s take a look at the period from January 1967 through December 2010.

The S&P index had an annualized average return of 9.87%.  During this time, the return on 3 month certificate of Deposits as measured by the CODI index was 6.25%.  But inflation during this period was 4.4%.  This means the real returns (nominal return minus inflation rate) is 5.47% for the S&P index and only 1.85% for the 3 month CDs.

	S&P	3 Month CD
return	9.87%	6.25%
real return	5.47%	1.85%

                                                 

So, 1.85% is all you would have pulled out in actual growth in CDs.

Recently, there is a strong argument to  made that the federal Reserve has been keeping interest rates below the rate of inflation which means negative real interest rates—but that’s a topic for a different discussion.

Not to mention the tax implications as regular accounts are taxed at ordinary income rates as opposed to tax benefits for certain plans such as IRAs—traditional and Roth.

The “guaranteed”  returns don’t seem too impressive when you consider the inflation rates.