Author Topic: CD vs Stocks/Bonds  (Read 2616 times)

DrumAllDay

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CD vs Stocks/Bonds
« on: April 06, 2017, 10:32:48 AM »
This is just a hypothetical situation, as I am not anywhere close to FIRE at this point in my life.

Say I determined I need $20,000 per year to cover expenses and to live a good life in retirement. If I saved a nest egg of $1 million and I put it in a CD that yields at least 2%, wouldnt that be the safest option? I realize CDs are only for set amounts of time, but you could keep putting it in CDs until the rates drop under 2% and at that point you could reinvest it in stocks/bonds.

Wouldn't this be a preferred method for somebody who is content on keeping their principal and wants an absolutely worry free form of retirement.

I've seen CD rates slowly climb higher near 2% around me and this made me think about this situation.

Thanks!

oldmannickels

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Re: CD vs Stocks/Bonds
« Reply #1 on: April 06, 2017, 10:39:50 AM »
If you were 100% in cd's and that income would be able to cover your $20k you would still have inflation risk that could erode at your buying power and capital.

GreatLaker

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Re: CD vs Stocks/Bonds
« Reply #2 on: April 06, 2017, 11:20:41 AM »
Over a 20 year retirement with 2% inflation the purchasing power of a dollar will drop to 55 cents. To buy the equivalent to $20,000 in today's dollars will cost you $36,000 in 30 years.

So if you only save in risk free CDs you will need to save a lot more before retirement is feasible.

DrumAllDay

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Re: CD vs Stocks/Bonds
« Reply #3 on: April 06, 2017, 01:43:04 PM »
That's true, I forgot to consider inflation.

I get how inflation would erode my purchasing power but isn't inflation sometimes overstated? Especially for Mustachians, who buy far less materialistic items, I feel like inflation is not quite as big of a burden as it seems.

If the price of chicken goes up, I will buy pork instead. If the price of cars go up it has no effect on me because my car will last longer and I will not need to buy one as frequently. There are hundreds of examples of ways to avoid the full effect of inflation.

With that being said, I still see how it will eat away at the buying power of my 2% interest.

Hondo

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Re: CD vs Stocks/Bonds
« Reply #4 on: April 06, 2017, 02:53:23 PM »
Someone in this forum suggested buying consumer items on a cash-back credit card. That is great advice. I have a 2% cash-back card from Fidelity, and all of my family's food (groceries and dining out) expenses are paid for with the card. This negates up to 2% inflation in our food expenses. We could do this for insurance, gasoline, and utility expenses too.

If your housing costs are fixed, either through outright ownership or a fixed rate mortgage, inflation will have little impact on your core housing expenses.

So that leaves the question; what impact will inflation have on your budget if you take steps to minimize the impact of inflation? My answer to that question is; not too much.

Hargrove

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Re: CD vs Stocks/Bonds
« Reply #5 on: April 06, 2017, 03:06:44 PM »
Inflation compounds against your total money saved. The card only gives you a rebate 2% once on money and only when you spend it. NOT a counter for inflation.

It doesn't matter that Mustachians don't buy junk. Inflation is how your money grows or doesn't, not how it's spent (or not).

Hondo

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Re: CD vs Stocks/Bonds
« Reply #6 on: April 06, 2017, 03:20:11 PM »
Inflation is quantified by the Consumer Price Index (CPI).

The CPI is "a measure of price changes in consumer goods and services such as gasoline, food, clothing and automobiles. The CPI measures price change from the perspective of the purchaser. U.S. CPI data can be found at the Bureau of Labor Statistics."

This means inflation is a function of consumer prices. Consumer prices are not an issue until you pay a price for a consumable good or service. As a consumer, inflation doesn't degrade the value of your 'stache unless and until you spend money.

Hargrove

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Re: CD vs Stocks/Bonds
« Reply #7 on: April 06, 2017, 09:39:57 PM »
Inflation is quantified by the Consumer Price Index (CPI).

The CPI is "a measure of price changes in consumer goods and services such as gasoline, food, clothing and automobiles. The CPI measures price change from the perspective of the purchaser. U.S. CPI data can be found at the Bureau of Labor Statistics."

This means inflation is a function of consumer prices. Consumer prices are not an issue until you pay a price for a consumable good or service. As a consumer, inflation doesn't degrade the value of your 'stache unless and until you spend money.

Inflation degrades the value of your 'stache whether you spend it or not. Money has a value. Inflation erodes it.

As for that 2% card, here's a very quick example.

Savings: $1,000,000
Inflation damage from 3%: $30,000 spending value lost
Spending that year: $40,000
Rebate on your 2% card: $800

Year 2, that same big pile of savings gets hit for the full force of inflation, but you're still getting rebates like 800 bucks. The card does almost nothing to counter inflation by redeeming 2% of your total 'stache just the one spend through, while inflation hits the entire 'stache every single year.

You want stocks to work for you.

GreatLaker

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Re: CD vs Stocks/Bonds
« Reply #8 on: April 06, 2017, 10:01:22 PM »
And the 2% cashback card only offsets inflation on spending in your first year. In the second year 2% inflation hits your spending 1.02^2 = 4.04%. By the 10th year it is 1.02^10 = 21.9%. A 2% cashback card will not be much help. And it only offsets 2% on things you can pay on credit card, excluding items like property tax, insurance, utilities that usually cannot be purchased on a credit card.

Substituting pork if the price of chicken goes up? What will you substitute for property taxes or rent, electricity, water and natural gas when those prices go up?

Inflation may be easier for a spendthrift to deal with than a frugal person, as spendy people have more places to cut back.

Bottom line is anyone retiring with no room in their plan for inflation is taking a massive risk of a seriously degraded standard of living after a decade (or 2, or 3 or even 4 for very early retirees).

Radagast

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Re: CD vs Stocks/Bonds
« Reply #9 on: April 06, 2017, 11:14:06 PM »
I don't see how that would work out well in the long run. Your "real" inflation adjusted spending would decline every year, so that after 40 years you'd be down to only $9,000 spending per year. Your principal would also be worth half as much. There is too much risk there from unexpected spikes in inflation. Bill Bernstein in "Deep Risk" thought unexpected high inflation to be both the most likely deep risk, and the most easily avoided. May as well avoid it.

If I could get to the point of having a 2% safe withdrawal rate I'd debate between Vanguard Total World Stock index, where I could live on the 2+% dividend which self adjusts for inflation and is near risk free, and Vanguard Balanced Growth fund (60% stocks, 40% bonds) which invests in all those stocks plus global bonds, and do the same thing. CD's would cut your money and spending in half after 40 years. Balanced Growth would double your money while matching your spending to inflation. VT should triple your money while paying a dividend that exceeds inflation.

As a rule, don't use only CD's for durations longer than 5 years. As always, I have a rule of thumb for minimizing chances of a bad outcome for various timeframes.
Timeframe Bond/CD Allocation 
(years)      (%)
10             80
20             40
40             20
80             10
« Last Edit: April 06, 2017, 11:26:21 PM by Radagast »

Radagast

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Re: CD vs Stocks/Bonds
« Reply #10 on: April 06, 2017, 11:24:46 PM »
To continue to poke at the 2% card claim: Nope. A 2% cash back card in an environment of 2% inflation effectively lets you buy this year's products at last year's prices. Cool, but not an inflation prevention. That is because inflation compounds, while 2% cash back does not. Nothing against the Fidelity card, I have one too and think it is great. An example showing inflation and the effects of using the card over 20 years of 2% inflation:
Year  Price         Price after 2% cash back:
1   $100.00   $98.00
2   $102.00   $99.96
3   $104.04   $101.96
4   $106.12   $104.00
5   $108.24   $106.08
6   $110.41   $108.20
7   $112.62   $110.36
8   $114.87   $112.57
9   $117.17   $114.82
10   $119.51   $117.12
11   $121.90   $119.46
12   $124.34   $121.85
13   $126.82   $124.29
14   $129.36   $126.77
15   $131.95   $129.31
16   $134.59   $131.90
17   $137.28   $134.53
18   $140.02   $137.22
19   $142.82   $139.97
20   $145.68   $142.77
Note you could hypothetically reinvest the 2% cash back. I didn't feel like adding that to the spreadsheet (tired).



Radagast

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Re: CD vs Stocks/Bonds
« Reply #11 on: April 06, 2017, 11:32:37 PM »
That's true, I forgot to consider inflation.

I get how inflation would erode my purchasing power but isn't inflation sometimes overstated? Especially for Mustachians, who buy far less materialistic items, I feel like inflation is not quite as big of a burden as it seems.

If the price of chicken goes up, I will buy pork instead. If the price of cars go up it has no effect on me because my car will last longer and I will not need to buy one as frequently. There are hundreds of examples of ways to avoid the full effect of inflation.

With that being said, I still see how it will eat away at the buying power of my 2% interest.
It seems nice to think that, but if I forecast my life expenses, over my life they have actually been growing more quickly than inflation. Education and health care seem likely to be two big ones for me. After that are housing, food, recreation, and utilities which are more closely related to inflation. Plus, I don't wish to live a gradually declining lifestyle that leaves me increasingly destitute on the same schedule as my declining ability to work.
« Last Edit: April 06, 2017, 11:47:03 PM by Radagast »

Al1961

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Re: CD vs Stocks/Bonds
« Reply #12 on: April 07, 2017, 09:33:17 AM »
Have you investigated historical spreads between CDs and the CPI?

By coincidence, I went looking for information on just this earlier this week. Canadian data is elusive, but perhaps US data is more available. Here's what I found:

https://www.ratehub.ca/blog/files/2015/04/history-of-gic-rates-ratehub.png

Until about 2000, GICs (CDs) offered real returns of maybe 3% on average, even in high inflation periods. That real return has narrowed to basically 0-0.5% today.

My 85 year old mom only invests in GICs. She made very acceptable risk free returns for decades under that strategy. These days, she's just keeping up with inflation, but that's OK. She's still a net saver.

Who knows what tomorrow will bring. Will we go back to the spreads of the late 20th century? Will the real return go negative?

DrumAllDay

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Re: CD vs Stocks/Bonds
« Reply #13 on: April 07, 2017, 10:49:53 AM »
And the 2% cashback card only offsets inflation on spending in your first year. In the second year 2% inflation hits your spending 1.02^2 = 4.04%. By the 10th year it is 1.02^10 = 21.9%. A 2% cashback card will not be much help. And it only offsets 2% on things you can pay on credit card, excluding items like property tax, insurance, utilities that usually cannot be purchased on a credit card.

Substituting pork if the price of chicken goes up? What will you substitute for property taxes or rent, electricity, water and natural gas when those prices go up?

Inflation may be easier for a spendthrift to deal with than a frugal person, as spendy people have more places to cut back.

Bottom line is anyone retiring with no room in their plan for inflation is taking a massive risk of a seriously degraded standard of living after a decade (or 2, or 3 or even 4 for very early retirees).

Yes I agree that inflation needs to be considered but it seems that the inflation rate effects each person differently. Not every consumer buys everything in the CPI and each category/item in the CPI is weighted differently for each consumer.

All in all, I would probably stay away from CDs as a large part of my retirement portfolio. I would probably just use them as a long term savings account.

GreatLaker

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Re: CD vs Stocks/Bonds
« Reply #14 on: April 07, 2017, 11:04:37 AM »
It seems nice to think that, but if I forecast my life expenses, over my life they have actually been growing more quickly than inflation. Education and health care seem likely to be two big ones for me. After that are housing, food, recreation, and utilities which are more closely related to inflation. Plus, I don't wish to live a gradually declining lifestyle that leaves me increasingly destitute on the same schedule as my declining ability to work.

Good point Radagast. To some extent I think governments like it when inflation as measured by CPI is lower than broader measures of inflation. Many social programs and entitlements are indexed to CPI inflation, so it's a win on budgeting for the government if those payment obligations go up less.

A lot of consumer goods have dropped dramatically in price, especially electronics, software, clothing, travel. So inflation hits different consumers differently. Higher income people with more disposable income can spend more of their income on consumer goods, that have dropped most in price. Lower income people must spend more of their income on energy, housing, education, health care etc. So inflation  hurts low income people more than high income people.

Personally I would not plan a couple of decades of retirement without allowing for inflation in my analysis.  2% inflation has a big impact over a couple of decades. Higher inflation like that experienced in the 70s and 80s is really corrosive to fixed incomes.