One of the most fundamental characteristics of investing is the balance between risk and reward. More often than not the higher the risk the higher reward. This characteristic draws investors and traders to the stock market year in and out. Furthermore it can be stated buying public equities is one of the most risky investments one can make. On the other hand, as previously stated, the higher the risk the higher the return.
A different kind of investment is a Certificate of Deposit (CD). It is simple to invest in a CD. You can purchase CDs from a bank or similar entity. To buy a CD you simply pay up front a fixed amount and receive the initial investment plus interest at the maturity date; which can be six months, one year, two years, three years, etc. CDs carry a very low risk and at times offer high rewards compared to the equities market. This is where the battle between stocks and CDs begin. Have CDs returned more to investors than stocks at any given time? If so, which equities have underperformed CDs over the past decade and will this trend continue?
Before I begin it is important to note three things. First, many public equities have performed very well over the past two decades, but the examples I will provide have underperformed CDs and are highly traded and held by institutional investors. Secondly, there are several types of CDs; which include callable CDs, brokered CDs, bump-up CDs, liquid CDs, step-up or step-down CDs, variable rate CDs, add-on CDs, and zero-coupon CDs. However in order to keep everything concise and simple, I will use CD rates compiled by Jumbo CD Investments Incorporated (JCDI). And I will assume the CD rates are fixed.
The first point is simply the fact that CDs are FDIC insured and stocks are not. This may come as no surprise, but this makes CDs much less stressful than the equities market. For instance, purchasing a one, two, three, four, or five year CD in 2000 would have substantially outperformed the SPDR S&P 500 ETF (NYSEARCA:SPY). Including dividends, the five year CD outperformed the SPY by about 2200bps (basis point). Therefore not only did the CD outperform the broader equities ETF, but also the CD carries a safe haven from the economy assuming the initial rate is fixed. On the other hand securities are most definitely not insured and any losses result in permanent losses that cannot be recovered unless the underlying security trades higher.
One important note to make regarding the above statement is the fact that this note -- up until this point -- is looking back in time. Meaning that at the time, in 2000, it would have been nearly impossible to correctly predict the market was going to underperform CDs over the next five years. With that said, I will discuss the future of CDs later.
From here though, I will now let CDs and stocks go to battle again. In this round CDs will go up against some of the most held securities on the market. Keep in mind dozens of strong companies have outperformed CDs over the years including the likes of Apple (NASDAQ:AAPL), Exxon Mobil (NYSE:XOM), and The Coca Cola Company (NYSE:KO). Nevertheless there are several upper echelon companies that have not returned as much as a standard five year CD over the past five years.
First off, let's revisit the SPY beginning in January 2006. From January 2006 through January 2011 the SPY price declined about 1.012%. Including dividends over this five year period SPY returned 8.199% to shareholders. On the other the five year CD in 2006 returned 5.705%.
This illustrates two points: 1) dividends are an important aspect to investing and can sometimes make up for a losing security; and 2) investors need to ask whether it is better to invest in SPY or a CD moving forward with the economy possibly facing severe weakness over the next two years.
Before continuing it is important to note I am not allowing for reinvestment of dividends in these scenarios. If this were allowed, the percent return would slightly increase. Nevertheless the SPY outperformed the five year CD over this five year span, but is 249.4bp worth the risk? This brings back the question of risk vs. reward.
In retrospect the reward of the equities market beat the possible risks. But this same situation can be applied to the future. If perhaps you were told you can buy a five year CD with an annual interest rate of 1.20% (6% over 5 years assuming the rate is fixed) or you were given the option to invest in the SPY that could pay roughly 7-11% in dividends; which would you choose? SPY can easily be argued the better investment, but what about the inherent risks?
The dividends are far from guaranteed and the price of SPY could easily drop to the 90-100 level. Therefore in a weak economy the SPY's dividends may decrease up to 50%. Now, this same argument can be directed towards the five year CD as well. If the CD rate is not fixed, the rate could be dropped at any given time and the SPY's dividends will further outperform the CD. Furthermore if the SPY's price does not decrease substantially the CD would be the worse investment.
This brings us back to the idea of insurance. While the CD is federally insured against an unlikely bankruptcy of the bank issuing the CD; the SPY is not insured at all. Therefore theoretically the price of the ETF could fall to $0. Please note this is virtually impossible, but there is still a nano-percent chance of this happening. Therefore if both investments suffer a worst case scenario, the CD will come out on top.
Does this mean investors should simply fill up on CDs? No, this does not mean investors should fill up on CDs. Keep in mind, hundreds of companies have generously outperformed CDs, but CDs are a way in which investors can keep a portion of their portfolio from economic weakness. In fact, in some instances banks may raise the rates of CDs during economic hardship to raise funds.
This brings up another question one might ask. If banks raise rates of CDs during economic hardships, should investors fill up on CDs during severe equity market weakness? No, investors should not do this for one fundamental reason. This reason is that the money placed into CDs is locked away for a set period of time; unless you want to face a hefty fee. Therefore when the market bottoms, which is inevitable, your money will be locked away in a CD for x amount of years. It is important to note I am not suggesting investing after a security or broader market plunge because a second tumble is certainly possible. But if investors are able to buy into a recovering equities market the returns will be substantially greater than the CD.
Another statement one might be thinking is, "well I don't invest in the SPY, so I am safe from long periods of weakness." Perhaps, but this is not exactly true. While many companies have performed well over the years; several major companies have substantially underperformed the five year CD.
Several major names that have significantly underperformed the five year CD are Dell (DELL), Micron (NASDAQ:MU), Citi (NYSE:C), Alcoa (NYSE:AA), Sunuco (NYSE:SUN), AMD, and Bank of America (NYSE:BAC). As you can see all sectors and companies of all sizes are capable of underperforming the five year CD. With that said, as previously mentioned many other companies have outperformed the five year CD. Some of these are EMC, IBM, Amazon (NASDAQ:AMZN), Bed Bath and Beyond (NASDAQ:BBBY), ConocoPhilips (NYSE:COP), and Continental Resources (NYSE:CLR) to name a few.
Beginning in January 2006 through January 2011 Microsoft's share price increased 6.280%. Including dividends, long term shareholders would have received a 14.864% return on their initial investment over five years. This more than doubles the amount they would have received from a five year CD in 2006; which was 5.705%. Clearly over this five year period Microsoft, and thus securities, is the winner. However if a different scenario unfolded this would not be the case.
Let us assume perhaps an investor in 2006 decided to pick up Microsoft in March instead of January. From March 2006- March 2011 Microsoft would have returned 3.275% to investors; which is below what the five year CD returned over that period.
The most prominent argument I see stemming from this will be that I am simply searching for a point in time where the five year CD outperformed Microsoft's security. Is this true? Yes and no because, as I proved, from January 2006- January 2011 the security outperformed the CD. However, on the other hand I am not searching for any five year period where Microsoft's share price and dividend growth is below 5%. The above instance is one period where a five year CD outperformed Microsoft's security, but there are several other points where this occurs as well.
Over the same five year period from January 2006- January 2011 News Corp. returned a net loss to shareholders of 1.289%. As we know, the five year CD returned 5.705% over this period assuming the rate is fixed. Unlike Microsoft, there is no two points in the last 5 years where News Corp. would have returned more to shareholders than a five year CD. The same cannot be said regarding the 1 and 2 year CDs. If perhaps investors bought News Corp. at any time in 2009, that particular investment would have returned more than a 1 or 2 year CD.
What importance does this information have on the future? The above examples are important for future investment decisions for several reasons. These examples illustrate how two well respected companies can underperform one of the simplest and most safest investment options on the market. Therefore it brings back the question of risk vs. reward.
More specifically, regarding News Corp., it can be assumed based upon earnings, industry trends, and technical analysis that CDs are likely to outperform News Corp's combination of share price and dividend payments to shareholders. Furthermore, it can be assessed that companies such as News Corp. carry a much higher risk with less of a reward than a CD. And if the reward of a security is less than the reward of a CD, the risk is intrinsically too high.
On the other hand the same cannot be said about Microsoft. Even though several spans of Microsoft's security underperform a CD, it is difficult to determine a proper risk vs. reward pattern for Microsoft. It is simple to state Microsoft's risk is substantially higher than the reward but this would be irresponsible and premature. Unlike News Corp., Microsoft has a much more innovative market. All it takes is one major product to change technology for the better and shareholders will be handsomely rewarded. How likely is this to happen? Well, this gets back to the grey area of risk vs. reward because the potential of Microsoft to produce a game changing product is there, but how likely is this of happening?
There have been several points that should have been noticed. The first is that CDs are easily capable of outperforming securities. And since CDs carry a high reward with a significantly lower risk than securities, CDs should not be ruled out. This pattern becomes more important in the current market. Since the present economic environment is shrouded by volatility and unpredictable shifts an investor that is simply buying and holding for a long period of time may not receive as much as a CD. It is difficult to determine how long this whimsical market will last, but with Europe crumbling and the United States Presidential Elections approaching, I assume this volatility will continue for possibly 12-14 months.
Another point to remember is that any company is vulnerable to being outperformed by a CD. Even a giant like Google (NASDAQ:GOOG) is prone to be outperformed by CDs. There may not be any significant periods in the past, but with Google's growth slowing and no dividend, we may see CDs outperform the share price in the future.
As questioned before, does this means investors should put the majority of their investment portfolio into CDs? No I am not recommending this at all. Even though CDs are exponentially safer, the truth is CDs offer very little reward compared to the majority of public securities. With that said, investors should at least consider a CD when researching a long term holding. If investors are simply investing in a company for a dividend, it may be a better investment to purchase a CD. This may be a highly arguable statement, but the truth is dividends should not be a reason to buy securities. This reason is the fact that the share price could easily plunge causing the investors to take substantial losses and possibly receive a decreased dividend; which is common during market weakness.
In the end each individual investor is different. Some people thrive when the pressure is on and love to test the boundaries of risk vs. reward. On the other hand many young investors have a tendency to forget the basic concept of risk vs. reward. I must remind you it is virtually impossible to correctly predict if a five year CD will outperform a certain security five years from now. And this is where the hazy part of risk vs. reward comes in. Since you cannot predict the risk or the reward of a certain security five years from now, it is also premature to assume a certain security will tank over the next five years and conclude that you should only invest in CDs.
It may be difficult to come to a conclusion regarding which is better regarding CDs or securities, but what can be said is both have potential upside that the other does not have. While securities could possibly grow over 100% in a five year span, a CD cannot. On the other hand, securities could plunge 80% in five years while the CD remains at the same rate of return on a fixed CD and possibly higher on a variable CD if the economy becomes severely weak. The best scenario is to, as always, keep a fundamentally diversified portfolio and avoid hasty decisions.
Disclosure: I am long EMC.