Certificates of Deposit Will Be Paying Higher Returns in Days to Come

Beyond Buy-and-Hold #15

By Rob Bennett

Say that you don’t care to invest in stocks. What sort of return can you expect to earn in a super-safe investment class like certificates of deposit (CDs) or IBonds or Treasury Inflation-Protected Securities (TIPS)?

The answer today is — not much.

But today’s realities are unusual ones. Say that you made it a practice always to avoid risk and thus tried to lock in good returns when they were available from super-safe asset classes. What sort of return could you in those circumstances expect from investments that carried virtually no risk?

At the top of the stock bubble,TIPS were paying a bit more than 4 percent real. You could have locked that return in for 30 years.

But that too was an unusual situation. My guess is that that 4 percent return may have been a once-in-a-lifetime thing.

But I don’t think it would be entirely unrealistic to work on a presumption that you could obtain a long-term average return of 3 percent real from safe investments if you put your mind to searching for good deals and to locking them in for the long term when you discovered them. I am confident that you could obtain a real return of greater than 2 percent real if you put any effort whatsoever to the task.

Stocks pay an average long-term return of 6.5 percent real. We cannot realistically expect more than 3 percent real from the super-safe asset classes; some reasonable people would argue that we cannot realistically expect much more than 2 percent real. That’s quite a difference. Stocks generally can be expected to provide a return two to three times that available from TIPS, IBonds, and CDs. Why? What explains so large a disparity?

Buy-and-Holders will tell you that stocks pay greater returns because stocks are more risky. The conventional wisdom is that stock owners are being rewarded for taking on more risk through an Equity Risk Premium.

I don’t buy it.

Valuation-Informed Indexers believe that investors are compensated not for taking on real risk, but for taking on perceived risk. At times when stocks are super-risky (the late 1990s), the likely long-term return for stocks is actually quite low. At times when stocks are virtually risk-free (the early 1980s), the likely long-term return for stocks is mouthwateringly high. There is indeed some connection between risk and return. But the connection is a good bit more complicated than is suggested by the bald claim that stock investors obtain higher returns because stocks are a riskier asset class.

The conventional thinking is wrong because the logic chain on which it is based starts in the wrong place and advances in the wrong direction. The conventional idea is that the risk-free return is the natural return and the higher return paid by stocks is comprised of the natural return plus a risk premium. I believe that it works the other way around.

The natural return is the return paid by stocks (6.5 percent real). Saved money is put to productive use; it is used to expand business enterprises and the profits from such enterprises have in the United States always been sufficient to generate an average long-term return of 6.5 percent real. The puzzle we need to solve is not why the return for stocks is higher than the risk-free return but why the risk-free return is lower than the return on stocks.

Don’t the banks that collect the money deposited by the purchases of CDs put it to productive use? Don’t they earn from it something in the neighborhood of 6.5 percent real? If not, why not? They must know about the stock market. It’s been written up in all the big papers.

The money deposited in a CD is earning something close to 6.5 percent real. But the CD owners obtain a return far less than that. Why? People don’t like the riskiness of stocks. So market forces permit the payment of a lower return. It’s not that stockholders are being rewarded for taking on risk. It’s that non-stockholders are being penalized for failing to do so. It’s a Non-Equity Non-Risk Penalty that is responsible for the low CD returns.

The risk of owning stocks will diminish with the shift from the Buy-and-Hold Model to the Valuation-Informed Indexing Model. So the penalty for owning non-stock asset classes will diminish.

As stocks become less risky, the banks offering CDs will not be able to impose so high a penalty for those not willing to take on equity risk. This means that the return on CDs and other low-risk investments will rise to something a good bit closer to the 6.5 percent real return that is being earned by the entities making use of the invested money. As stock risk diminishes, non-stock returns will rise.

We live in exciting times for investors.

Rob Bennett developed the first simple retirement calculator that contains an adjustment for the valuation level that applies on the day the retirement begins. His bio is here.

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