David Letterman's Stupid Pet Tricks were funny and ran for 30 years. Wall Street's stupid investment tricks have been going on longer but aren't funny at all. This is a great example.
With interest rates on savings earning practically nothing, it’s little wonder I often field questions like this one:
What do you suggest for people with a lot of cash which is now in a money market and not earning much of anything, but who want something completely SAFE with LOW risk but gets a better interest rate?
Or this one:
Is there anything I can put my money in that is very low risk but better than the nothing that I get now?
Dealing with an interest drought
Guaranteed savings accounts are going through one of the worst interest droughts in history. Like refugees from the Dust Bowl, savers no longer able to scratch enough interest from their parched savings are being forced to wander in search of decent returns.
What’s a saver to do? If you’re like Dixie and Nancy — unwilling to take risk — then your only option is to wait for higher rates, which may come sooner than you think. But what should you avoid while you wait?
Stupid investment tricks
David Letterman’s Stupid Pet Tricks was a funny franchise that ran for 30 years. Wall Street’s stupid investment tricks have been going on longer, and they aren’t funny at all.
Case in point? Equity or market-indexed CDs.
My father-in-law went to the bank the other day to roll over a five-year CD within his retirement account. When he understandably balked at the miniscule rate he was expected to accept, he was introduced to an in-house, commission-based financial adviser. The adviser suggested a no-lose proposition: an FDIC-insured CD that also offered the potential for extra interest, courtesy of the stock market.
To understand why, take a look at some of the terms of this five-year CD:
- Minimum Rate: 0.75 percent
- Maximum Rate: 5 percent
- Basket of stocks the returns are tied to: Apple, Coke, IBM, Merck and Verizon
- How interest is determined: Every year on the anniversary date, if all five stocks are higher than they were on the inception date, you earn 5 percent. If even one is lower, however, you earn 0.75 percent.
These rates don’t compound. In other words, you earn interest only on your original investment. If you invest $1,000 and happen to earn 5 percent, or $50, after year one, your investment is worth $1,050. But if you earn 5 percent the next year, it’s only paid on the original $1,000, not $1,050.
In addition, while you can cash out a traditional CD early and typically be penalized only interest, cash this CD early and you can lose principal.
After looking it over, here’s the response I sent to my father-in-law:
In the very limited way you intend to use it, I guess it’s OK. But barely. Salient points:
- Expect to earn 0.75 percent rather than 5 percent. That’s the most likely scenario, because all five stocks have to be up on the anniversary date to earn the higher rate. Those odds aren’t good, even in a bull market, and this one is getting long in the tooth.
- You’re most likely going to have to hold it for the entire five-year term in order to get your principal. So be certain you’ll have the liquidity elsewhere in your IRA to meet any cash requirements, such as required minimum IRA distributions.
Since capital preservation is the primary goal and this product, if held to maturity, will at least accomplish that goal, I guess it’s OK. But if you’re dealing with a lot of money, I’d encourage you to consider other options.
For example, look at CD search engines, and you can find five-year CD rates around 2 percent. That’s a sure thing that at least offers limited liquidity. Better yet, bite the bullet, take out a shorter term CD and wait for rates to rise.
In my opinion, this investment, like many pushed by commissioned Wall-Streeters, is just one of many stupid investment tricks offering more sizzle than steak.