How a High Rate CD Account Can Dramatically Alter Investment Portfolio Risk
It’s true. Adding a low/no risk fixed income asset like a fully insured high rate CD (or portfolio of smaller CDs to ensure they have FDIC coverage) can dramatically alter the shape of your risk/return profile of your retirement nest egg. The beauty of adding a fixed income high rate CD (sponsored CD link) is that it sets a base-line return for a zero risk investment – which when combined with a portfolio of risky assets (stocks, ETFs, mutual funds, etc.) it creates a flat sloped line between zero risk (the risk free asset) and your optimized / efficient portfolio of risky assets.
A typical portfolio of risky assets (even when perfectly / efficiently balanced) will have a long curve which typically ends somewhere around 6-8% standard deviation (risk level – meaning 95% of the time your portfolio results will be X +/- 12-16% – 2xStandard deviation). Given that typical stock market returns range about 10-12% (depending on current interest rates) an average year’s stock returns should be -2% to 44% (see inset box). As you might imagine financial planning pretty well becomes impossible with those kinds of variability in numbers.
A High Rate CD as a Risk Free Asset Really Extends the Return Options - Click for Larger Image
Inset Box: An efficient portfolio curve takes into account the mitigating effects on risk of having multiple assets in a risky investment portfolio. This is the impact of what is meant when someone talks about ‘adequate diversification’ in an investment portfolio. The straight lines in the chart represent a simple combination of a “risk-free” fixed return asset (like a CD – and no, no asset is truly ‘risk free’) with a risky asset portfolio (each line represents a different type of account, a low rate savings account, a high rate savings account, and a high rate CD). The higher the return on the ‘fixed asset/risk-free asset’, the better the overall performance of the portfolio – AND the greater likelihood of avoiding the temptation to take on bad risks.
It is for this reason financial planners recommend adding a fixed return asset such as a high rate CD or government treasury bond to reduce the volatility of investment results. Watch what happens to the numbers when we add a risk-free type asset to our porfolio. Given our asset is risk free – or de-facto risk free in the case of a high rate FDIC insured CD* now investors have a broadened selection of significantly less risky choices or asset combinations. Whereas previously our lowest volatility portfolio was around 6-8%, now we can create combined risk free / risky portfolios with any possible risk level we choose – 0% standard deviation right out to infinity. (editor’s note: the borrowing rate is usually significantly greater than the risk free rate – altering the slope of the curve at the high end of the risk scale)
Have a look at how the lower end of the risk/return graph is opened up to investors with the usage of a high rate risk free asset (a high rate CD, treasury bill/bond/note, or high yield money market or savings account). This is possible because the riskiness of a two asset porfolio is equal to the sum of the weights of the investments times the riskiness of those assets. How do we know which investment portfolio to choose along our curve? We choose the one where the risk free asset just touches the top of the risky asset curve at a single (tangential) point. Honestly – creating the risky asset curve and selecting the point of tangency is waaaay beyond the scope of this article – but the point is your financial advisor ought to be able to do this. If he can’t provide you with a projected risk / return curve like the one I show above… get a new financial advisor.
* – A high rate CD or savings account is not an entirely risk-free asset – particularly the interest portion of the asset. Any debt security (which is technically what a savings or CD account is – relative to the bank’s point of view) carries some sort of default risk and accrued interest income is not covered by FDIC insurance. Bear that in mind when selecting a high return CD, money market account or high interest savings account to match up with your risky asset portfolio.
