August 6, 2009

CD's linked to markets, currencies, inflation

The other day I saw an article ‘Indexed’ CDs Aim to Balance Risk and Safety on WSJ about Certificates of Deposit (CD)s that are linked to stock market gains. I hadn't heard of this kind of investment before and it interested me. I've heard of insurance policies linked with returns indexed to the stock market but not CD's. I did a little research (i.e. went to Google) and I found that there are other types of CDs out there with returns other than simple fixed interest. There are CDs linked to foreign currencies and even CD's linked to the inflation rate for college tuition. As a group I'll call these indexed CD's.

Why would you want a CD linked to something? First of all lets consider why you'd want to invest in one of these things. The primary reason someone might want to have an indexed CD is that you want to participate in a style of investment but you want to limit your risks. Say you'd like to be in the stock market but you're wary of the losing your money. A CD indexed to the market could give you a % of the potential stock market gains but little or no exposure to stock market losses.

They are FDIC insured so that gives you protection for your money. If the bank or financial institution goes bankrupt your principal is secured. You can't say that about stock investments or most other forms of investment.

Well that all sounds good, but what are the down sides? The uncertain nature of the returns is a negative for sure. I'd rather take a guaranteed 5% than a chance at 0-15%. I'd say a major con for this kind of investment is the complexity. You don't know what your returns will be and its probably not easy to figure out your return on an annual basis. The added complexity may make it harder to decipher what you may be paying in fees or expenses. Last but not least, the worst thing about complex investments is that they are simply not easy to understand. Never invest in something that you don't understand.

While novel and interesting, this kind of investment is likely not a good idea for most people. If you want to reduce risk then stick to a plain old high rating bond.

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