The Informed Investor
In today’s volatile world, the stock market can move quickly, which can be unsettling. It may be tempting to put your money into cash to wait out all the market uncertainty and economic turmoil.
Unfortunately, today’s markets are not as simple as they were in past decades. The traditional “flight to safety” seemed to make sense when certificates of deposit or bonds were viable ways to wait out the storm. Back in the 1970s and 1980s, CDs were paying double-digit interest rates. But today, those same
instruments pay barely one half of a percent annual interest…or even less.
For example, assume you have $1 million that you would like to keep out of harm’s way. So you put it into a certificate of deposit. According to Bankrate.com, average interest rates this week for CDs are:
– 0.55% for one year (1)
– 0.70% for five years (2)
So your one million dollars would earn $5,500 for one year. If you commit to five long years, you would receive a slightly better return in addition to your original investment. At least it is safe and you are guaranteed not to lose any of it, right?
The Invisible Enemy
While it “seems” that you are in the black and your money is safe, a stronger market force is actually reducing the value of your money due to inflation. As Ronald Reagan put it, “inflation is a sneaky devil that can cause you harm without you even noticing.”
Now, we hear governments and the Federal Reserve say inflation is low—very low. In fact, many governments are trying to increase inflation to reach certain targets.
The measured inflation rate IS after all, quite low. According to the Bureau of Labor Statistics, over the past 12 months, the Consumer Price Index increased only 1.2%.(3)
Even at this paltry rate, however, it still eats up all of your return from CDs, and part of your principal.
When your certificate of deposit term is over, you will receive your initial investment back in addition to the interest you were paid. But because of inflation, that money will buy around 1.2% less. So even though you collected some interest and the dollar value of your cash has increased, the purchasing
power of that money has fallen by more.
However, no bank statement ever points that out. Since no one sees it, you may not notice that inflation over time is gradually depleting your wealth. When the inflation rate outpaces interest rates, you are only falling further and further behind.
What is the Real Inflation Rate?
The Bureau of Labor Statistics (BLS) tells us that the cost of living only went up about 1.2% last year. But that is a statistic, and in the United States, some say that inflation statistics have been engineered over decades.
Because of this, the Consumer Price Index is the subject of significant controversy. (4) Many say it no longer adequately captures the true cost increase of day-to-day necessities.”
That is not a hard argument to make, since looking back, you do notice prices rising over the past years. Most of us do. For example, health care costs in the U.S. have been rising precipitously over recent years, far over 1.2% per year. All of your home and car insurance premiums may be increasing, too. Food costs often seem to go up more; have you bought a box of cereal lately? In 1970, you could purchase one for about 38 cents. Now, it costs three or four dollars, and the box itself is getting smaller.
If you have built a house lately, you may see that the cost of lumber has gone up dramatically, as have other component prices.
Years of engineering the consumer price index can make it seem somewhat out of touch with today’s actual cost of everyday necessities.
That is why your money must keep up with inflation. If it does not, there is a very real cost to you, as your purchasing power will weaken over time.
According to the BLS, you would have to earn at least 1.2% interest on your money to keep up, and with interest rates now hovering at about a third of that, that is not even a possibility with certificate of deposits.
But that is not the only risk you face.
What is Your Actual Return?
To add insult to injury, on top of losing out to inflation, you also normally have to pay tax on that interest you earn.
So take your tax rate right off the top, and add that to your annual loss.
The bad news does not end there. Today’s tax rates are historically quite low. With all the spending needed for the pandemic, it is likely that tax rates only have one direction to go in the future, and that is up.
If and when tax rates increase, your real loss will increase.
Jim Grant, the founder of Grant’s Interest Rate Observer, a twice-monthly journal of the financial markets, likes to call today’s low interest rates “return-free risk.”
So, unfortunately, this “flight to safety” is not wealth preservation anymore. It is wealth erosion.
Early in 2020, famed hedge fund manager Ray Dalio was quoted as saying “cash is trash”. (5) With interest rates now forecast to stay low, he may be right until rates rise.
Of course, that does not mean throwing caution to the wind and putting all of your money into stocks or other investments. It simply means your investments should be broadly diversified and monitored frequently.
When the equity markets start to feel rocky, keep in mind the potential downside of staying in cash. Being aware of inflation can give you a better perspective of the long-term benefit of being in the stock market during times of economic turmoil.
So while the economic environment is continually changing and challenging, you can still build and maintain a balanced portfolio in today’s uncertain world. Just remember that cash is not necessarily the safe haven it used to be.
3 “Consumer Price Index — October 2020.” Bureau of Labor Statistics, BLS, 12 Nov. 2020,
4 Palmer, Barclay. “Why Is the Consumer Price Index Controversial?” Investopedia,
Investopedia, 3 Nov. 2020, www.investopedia.com/articles/07/consumerpriceindex.asp.
5 Sheetz, Michael. “Ray Dalio Says ‘Cash Is Trash’ and Advises Investors Hold a Global,
Diversified Portfolio.” CNBC, CNBC, 21 Jan. 2020, www.cnbc.com/2020/01/21/ray-dalio-
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