Are CDs Safe? Safe from What?
A special report regarding the potential for inflation that everyone should read before buying CDs, Annuities or Bonds . . .
Wise investors plan for what is likely to happen in the future and invest on that basis rather than on what happened last year. The relative stability of CDs make them attractive to investors worn down by the market turmoil of the last 18 months.
But, there are no investments that are safe from all risks, even CDs. So let’s take a look at what current circumstances are suggesting could possibly be in the future for CDs and what the risks might be in these seemingly benign investments.
Treasuries, CDs and other dollar denominated investments have clearly worked better than many investments over the past year or two. This is normal during economic contractions like we saw in 2008. But last year is not what makes you money in investing. In fact, studies1 have shown that investing in last year’s winners is risky and leads to under-performance.
So, although CDs, annuities and Treasury bonds have recently performed well, what might the future hold for them?
In recent months the US Government has committed to spend $3 Trillion before even getting to the really expensive issues of health care, social security reform and education or the normal cost of running the government. $3 Trillion extra. Where is all of that money to come from?
The government plans to borrow it. But who do you know with a spare trillion or two to loan to the government? The US has the largest economy in the world by far, and it can’t come up with that much money. The Chinese and the oil sheiks have big money, but not trillions, and each of them are deep in their own economic problems and are planning to spend much of what they do have in their local economies.
If the federal government can’t borrow the money, then it will have to print it. And printing money is a classic cause of inflation. CDs and other investments denominated in dollars can be devastated as the value of the dollars in them plummets due to inflation.
With the specter of inflation looming, I looked at history for some guidance of what might happen if the government resorts to printing large amounts of money to pay for its spending.
History is rife with the dictators of small countries printing money causing the value of their currency to collapse in what is called hyper-inflation. Bolivia in 1985, Argentina in 1990, and several African nations in recent memory.
It happened in Germany (1922-23), Hungary (1946) and in Russia (two times in the past 100 years.) and those were not third world countries. I have on the wall in my office a $2 billion ruble bond issued by the czar in 1916. $2 billion is now a just piece of wall paper.
Could it happen in the U.S.? The only thing that has me saying “no” is my nationalistic pride. The facts speak otherwise. So lets look at what happens when hyperinflation does occurr.
In all cases hyper-inflation arrives shockingly fast. Argentina had 5,000% inflation in 19892. A $2 loaf of bread in January cost $100 in December. A $100,000 CD bought in January was worth only $2,000 worth of groceries by December. Your $100,000 would have been returned to you, but with a loss of 98% of one’s purchasing power.
The number of dollars were safe, but most investors really want more. They want what the dollars will be able to provide.
In Germany in 19223, $100,000 put into the bank in May bought only $6,000 worth of goods by November, and was worthless a year later. It took a wheel barrow full of money to buy groceries in 1923 Germany.
When governments have their backs against the wall, economically, they always seem to choose inflation as the least painful solution. But least painful to whom? The decision makers, perhaps, but not savers.
No one knows exactly how our current situation will turn out, I hope I am wrong in worrying about this. But, I do know that politicians benefit from inflation. It is the easiest way to wipe out the huge debts the government is amassing. However the real value of savings gets wiped out too, including CDs, annuities or bonds. Anything with a face value quoted in dollars would be at risk from inflation.
Investors planning to seek safety of CDs or annuities need to be mindful of the lesson I tried to impress upon students in my Yavapai College class for almost 20 years now, When someone says the word “safe” to you, your response should be “safe from what?”
Some folks think dollar denominated assets such as CDs, bonds and annuities may be safe, but safe from what? They may be safer from market risk and default risk than many other investments, but their big risk is from inflation.
The key to protecting one’s investments during inflation is to not be a lender. When you buy a CD you are loaning your money to the bank.
What is an investor to do? As always, I would advise you to stay flexible and diversify, diversify, diversify. Never have all of your assets in any one investment class, like dollar denominated investments that can all be affected by the same risk.
The assets that traditionally do best in inflationary times are hard assets – things you can touch and feel – things that are not denominated in dollars – such as oil, precious metals or real estate. Some investors seek to avoid inflation risk in foreign denominated bonds and CDs (if – a big if – that country does not also suffer inflation).
Investments that will fare the worst during inflation will be dollar denominated investments such as CDs, annuities and bonds that are to be repaid in dollars that might become worth less (potentially a lot less) before the maturity of the investment.
So before you go loading up on certain investments because you think they are safe, remember to ask “safe from what?” and make sure you are protected from those pesky other risks out there.
Don’t let your savings become wall paper.
1 A March 2004 study at the University of Cologne in Germany, “Family Matters: The Performance Flow Relationship in the Mutual Fund Industry” as reported in investopedia.com. Also a study, by Christopher R. Blake, associate professor of finance at Fordham University’s Graduate School of Business, and Matthew Morey, assistant professor of economics at Fordham reported by Mark Hulbert in the NY Times April 4, 1999.