CDs and Inflation: A Discussion of Risk

Investment News points out that CD buyers are getting hosed by inflation:

Savers who put their cash in longer-term certificates of deposit are losing out to inflation, according to Market Rates Insight.

The annual inflation rate of 3.16 percent in April topped the best 5-year CD rate of 2.4 percent, according to San Anselmo, California-based Market Rates Insight in a report today.

I bring this up not because CDs are necessarily bad investments, but because it illustrates the nature of risk.  Investors often think of risk far too narrowly—just in terms of volatility or loss of capital.

In fact, risk is all-encompassing, and like energy, can be neither created or destroyed. 

CDs are a good example of the latter point.  When you buy a CD, you have massively reduced your risk of capital loss.  (It would require the bank to go out of business and the government to refuse or be unable to pay off depositors—a vanishingly small risk.)  But you have simultaneously massively increased your risk of losing purchasing power due to inflation.  Your risk hasn’t gone away, it has just changed form.  Remember, risk cannot be created or destroyed.  You can pick your poison, but you can’t opt out.

The former point is almost always much harder for investors to grasp.  Your risk is the sum total of all of your exposures—and the sum total of all of the things you don’t own.  If you own a house, you have real estate risk, and US dollar risk if the asset is held in the US.  Less obvious is the fact that you now have the opportunity risk of not holding everything other than a house!  For example, owning your house precluded you from buying emerging market stocks, or Swiss Francs, or energy futures with the same money.  Depending on the relative performance of that investment opportunity set, your decision to buy a house could end up costing you a lot—relative to what else you might have purchased.

Psychologists will tell you that humans significantly overvalue the tangible relative to the potential.  As the saying goes, a bird in the hand is worth two in the bush.  Losing money that has already been earned hurts much worse than deciding not to put money into a stock that later doubles.  Losing money always feels worse than losing opportunity—and it is for this very reason that investors’ biggest losses are usually the ones they never see.  Opportunity loss typically swamps capital loss over an investor’s lifetime.  Like a black hole, opportunity cost is very real even if you cannot see it.  (Relative strength can be a great help in determining where opportunities lie—and which assets might be wise to avoid.)

Investing, then, is never without risk.  You are just navigating a set of tradeoffs, with different risks inherent in each.  Depending on the assets you own, your specific risks will be different from another investor, but your risk will remain just the same.

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