COVID-19 Diary Number 8 (July 14, 2020)

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It seems that many people have begun to see the market rally as an opportunity to get out whole, or nearly so, after the frightening losses of late March. They despaired three months ago when stock prices went off a cliff, and now that prices have regained much of the lost ground, they wonder if they should get out while the getting is good. They don’t have reason to forecast another plunge in values; they just want to avoid the pain of another March experience.

Such anxiety is understandable.  March’s stock price retreat was unnerving and no one wants to go through that again.  But before selling out, investors should consider two things:

  1. Do they have an immediate need for the money? If they do, then the recent price recovery is a wonderful opportunity for them to get out of stocks –– not because prices have risen, but because (as readers of these blogs should know well), they should not have been in stocks in the first place.  Equities are only for those who have no need for the money for at least five years.
  2. If they do not need the money now or for the foreseeable future, they should consider the investment alternatives. There are five choices, none particularly attractive compared with stocks.  Though some might offer less volatility than stocks, the cost to the investor is lower potential returns:

–Cash is one option.  Cash deposits and certificates of deposit (CDs), unlike stocks, offer assurances that you will get your money back no matter when you want it. But these “cash vehicles” pay extremely low returns.  Deposits — whether at commercial banks, savings banks, credit unions, or money market mutual funds — all pay less than one percent a year.  CDs pay a little more, but you must tie up the money for at least a year to get that higher rate of interest –– and you will pay a penalty if you take it out early.  This post will give you more detail.  In all cases, the returns on deposits are less than the rate of inflation.  The cost of living, in other words, is rising faster than what the investor can makes on deposits of any kind.  The real buying power of what you invest in these instruments will decline, even though the dollar amounts you get back will rise. 

–Quality bonds offer yields above the rate of inflation, but only slightly.  That might have an appeal, but the yields are still low.  What is more, the odds are good going forward that the yields will rise, which means that the bonds you buy today will lose value tomorrow.  For an explanation, see this post.

–You can get a higher rate of return if you are willing to invest in the issues of companies that are less credit-worthy.  But when you invest in these so-called junk bonds, you risk fluctuating prices or even the outright bankruptcy of the issuer, which makes this alternative as volatile and emotionally fraught as stocks.

–You could turn to commodities — precious metals, industrial metals, foods, etc.  If the economy does well, these prices will rise, as will stock prices.  But as with stocks, there is a significant downside on commodity prices should economic prospects deteriorate.

–You might take your investment funds overseas. Stocks and bonds in other developed markets — Europe, Japan, Australia, Taiwan — have all the same potentials and risks as those in the United States, so they hardly offer a haven for those wanting to flee volatility.  They do have a place in a portfolio, as explained in this post but they are not a hiding place for the frightened.  Emerging markets, as explained in this same post, have appealing long-term characteristics, but are actually more volatile than U.S. stocks.

If you want to be “cute” and take the risk, you might take some money out of equities and sit on it in the expectation that some future disappointment will bring a stock price retreat, and then you might redeploy that money effectively. I described this strategy here.  “Cute” is the best way to describe it, because it violates the basic principle that stocks are for the long term, and no investor, no matter how clever or well informed, can time market swings.

 

Certificates of Deposit

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With short-term interest rates above their lows, the popularity of highly liquid, insured accounts has returned.  Bank savings accounts are an option.  An earlier post focused on these and their like.  Because banks and other financial institutions pay a higher rate the more money you are willing to commit and the longer you are willing to leave it, certificates of deposit, (CDs) present an attractive alternative.

CDs commit you to leave a set amount, for a set time, with the financial institution for an agreed interest rate.  Because the financial institution can better plan what to do with the money than with a savings account (where the institution cannot anticipate how much and when you may withdraw), it is willing to pay a higher interest rate.  Financial institutions sell CDs in amounts of $1,000, $5,000, $10,000, up to $100,000, and sometimes more.  Like bank accounts, the FDIC insures these up to $250,000.  Some brokers also offer CDs.  These are not FDIC insured, but often the issuers make insurance arrangements with a private insurance company.

If you decide to buy a CD, make sure you can leave the money for the entire term, because there’s usually a penalty for early withdrawal. Some banks offer “liquid CDs”  –– these allow the withdrawal of funds without penalty before the stipulated term, but they usually pay lower rates than conventional CDs.  If you buy your CD through a broker, you may have the option to sell it back before its term expires, but this almost always lowers the interest rate.  (That broker will then resell the CD on what is called the “secondary market.”)

Some CDs offer flexible rates that rise if market interest rates increase. Typically, these guarantee that the rate originally quoted to you will not be lowered. Some banks will also let you set the terms of your CD.  These so-called “designer CDs” can be useful for savings aimed at college tuition, for instance, or other expenses where you know the approximate date you will need the funds.  These, too, often pay a slightly lower rate than conventional CDs, though typically not as low as liquid CDs.   Note that these flexible and liquid CDs have become less common in recent years.

Shop around.  CDs vary considerably from one institution to another, and rates can differ by as much as a full percentage point. The Internet offers the saver a great tool for making such comparisons.  All bank websites have information on all their services, including the rates on CDs and the associated conditions on term, early withdrawal, and the like.  Be careful: marketing often make things look more attractive than they really are.  Here are a few points to consider:

  • The tease: Some CDs offer a relatively high interest rate up front but after time pay a much lower rate.  Know how long the higher “teaser” rate will last.
  • How the bank/broker treats maturity: Will you receive timely notice when your CD is about to reach term and can you then roll it over automatically into another, similar CD, or can you stop the process?  Be sure you understand the rate offered by such a “rollover.”
  • Calculation of interest: Know whether the interest rate quoted is simple or compounded.  The best you can do with a simple rate is what is quoted up front.  A compounded rate, However, will calculate the interest periodically and post the interest to your account.  Because each interest calculation will include the interest previously paid, you will effectively earn interest on the interest, as described in several earlier posts –– a far more attractive arrangement than receiving simple interest alone.  For instance, a one year a CD that compounds daily will pay you 0.15 percentage points more for each 1 percent of quoted interest.  When compounded that way, a one-year CD quoting, say, 1 percent would effectively pay 1.15 percent.  A CD quoting 2 percent would effectively pay you 2.31 percent.  Though it might not seem like a lot, a $50,000 CD quoting 2 percent interest, would earn an extra $155, enough to justify making sure you’re getting the compounded rate.