Monday, April 3, 2017

Saving and Investing Risk Management

In the previous three posts on saving and investing I tried to ferrite out the relationships between a number of common ways of holding money until it is needed. It is always cheaper to borrow from our own savings than from a credit card.

The Christmas savings account is a good example. You earn pitiful interest during the year, but escape a 20% credit card bill during the next year. The account has served its overall purpose. You are earning interest at a rate of 20% for as long as you would have had to pay on your credit card balance.

Now, if we keep this same line of thinking for CDs, the 2% rate is also low, but much lower than the rate we would have to pay on a credit card health care bill balance (20%).

The CD carries zero risk. It is government insured by the Federal Deposit Insurance Corporation (FDIC). Even at an up to a 2% interest rate, buying a CD has not been a valid investment practice for several years. It has not been keeping up with inflation. In that respect the CD is not safe. When it matures it buys less than when it was purchased.

I have found more than one source stating that interest rates are strongly related to inflation rates as well as to government agency manipulations for political and financial reasons. CDs do have zero risk for short term savings.

Comparable CD Payout Rates and ETF Values
CDs have considerable investment risk if interest rates rise and rise fast enough. The fixed return CD lags the open market stock exchange. An exchange traded fund (ETF) follows an index closely; there is little lag. (The S&P 500 ETF was invented January 1, 1993, three years after I was forced to take voluntarily early retirement because of tobacco smoke allergies). Some 20 years have gone by before I learned about ETFs (and I think, finally understand them)!

The 5-year fixed term CD only matures three times (thin solid red line) at which points it equals the comparable ETF values. The ETF values can closely follow interest rates and the funds are always available (less trading costs and adjusted for market fluctuations).

You have to accept the investment risk that is muted by averaging the performance of many stocks in an ETF. The S&P 500, today, yields about 3 to 5 times that of a CD when you accept the risk.

The normal investment risk is manageable by having sufficient savings to bridge the time between a decline and a recovery to the former fund value on the investment. This is pure math and probability. You lose nothing if you do not sell during a decline.

It has little to do with your risk tolerance, trading habits, and investment advisors (who currently can charge more than your investment is making). Fortune tellers, around the world, do a good business doing what investment advisors do here in the USA.

Since investment advisors cannot predict the future (and their contracts relieve them of any liability from following their advice), you need a balance between fixed rate low paying CDs and variable rate, much higher paying, ETFs. How much of your ETFs are you willing to lose if needed to sell on a short notice (less than a month)?

Or can you charge unexpected costs to a credit card with a low interest rate, far below 20% if your CDs cannot cover the cost? You can if you have a good credit rating. And then, possibly, pay it off at the next billing with no interest cost.

CDs and ETFs complement one another. You save and invest starting with CDs. You gamble starting with ETFs. Now to live long enough to see how this all plays out. (We bordered on gambling when we bought the annuity from our house sale and moved to Provision Living at Columbia. They were best buys a year ago and still are.)

An afterthought: Holding money to fill in a decline in an ETF is, in effect, being a self-insurer. Then buying CDs with that money, where it earns some interest, makes the CDs the secondary insurer. This makes sense; a common investment practice. It makes a decline in an ETF, a planned for unexpected cost, that the annuity cannot support along with other unexpected medical costs.

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