The strategy an investor uses in choosing a particular CD from all of the available options has to do with how the money in the CD will be used and what place it has in the investor's overall portfolio.
Buying One Safe CD
One of the most common strategies involves purchasing a single CD as a safe, short-term place to store cash to fund a purchase or investment in the near future. Short-term CDs can have a time frame as brief as 28 days. There are also one-month, three-month and six-month CDs in this category, for example. With these CDs, investors plan an appropriate maturity date when they will need the money. It makes no sense to select a CD that matures a long time afterward, even though the interest rate may be higher on a longer-term CD. Timing is essential to this strategy.
Another strategy is to purchase a single CD as a conservative place to store money for the long-term. Some investors do not want to put their money into stocks, for fear of a decline in value. Instead, they put their money into a long-term CD that is insured against loss and that offers a rate of return that meets their investment goals. The longer the term, the higher the interest rate, in general. There are terms of one, two, three, four and five years – up to 10 years, with various half increments, such as 18 months and 30 months. The point is to earn as much return as possible for the length of time the money is invested.
Customizing the maturity schedule helps investors meet a need for the money long-term. With this method, investors put money into a long-term CD but reinvest the money in a short-term CD after the first CD matures. In this way, the investor can keep the money invested until right before it is actually needed.
Setting Up a CD Ladder
Sometimes, investors want to receive a CD's interest in a regular check, instead of reinvesting the interest into the account. With the income generation strategy, investors receive periodic payments that help them reach other financial goals. This strategy can also be implemented by purchasing multiple CDs that generate income. Staggering the different CDs' dates of interest payment can be beneficial, too.
Staggering the maturity dates of multiple CD accounts creates a CD ladder, with each CD as a "rung" of increasing term lengths. As time passes and the CDs mature, each bottom rung continually becomes the top rung. An investor might choose CDs lasting three months, six months, one year, and two years, for example. When the three-month CD matures, the money is invested in another CD account that will mature after the two-year CD. Then, the six-month CD is reinvested (at the end of its term) for a later maturity than that of the new CD, and the one-year CD (when it comes due) even later than that. In this way, the ladder continues on and on. This can provide investors with the security of knowing that cash will be accessible at regular intervals if they need it for something unplanned. It also allows income generation at staggered dates of interest payment.
Although laddered CDs require maintenance, picture the extra interest earned from splitting $100,000 into 10 separate $10,000 CDs. Some are in short-term accounts, and some are in long-term accounts that earn more interest. Each is timed so that the interest payments are spread out – with little time between payments. An investor who takes the interest by check (instead of reinvesting) benefits from the steady income generation of the CD ladder.
If the investor had instead put the entire $100,000 into one short-term account, the account would have calculated only one interest payment per year, quarter or whatever schedule applies. The payments would be spread out; the investor might go for long stretches of time without receiving an interest check. And, the interest would not be as high as with the laddered plan. Investors who are willing to keep pace with changing income needs and changing interest rates can certainly benefit from designing and maintaining an appropriate CD ladder. (Step Up Your Income With A CD Ladder provides more information about how these instruments offer safe capital, predictable cash flow and simplicity.)
A CD as Part of a Growth Strategy
CDs can also be used as part of a conservative growth strategy. Investing in an index-linked CD, such as a bull or bear CD, provides opportunity for greater returns than those associated with traditional CDs, while still offering insurance protection. This strategy allows investors to take advantage of stock market changes without facing the losses that can be involved in the market. With this method, the CD investment can grow beyond the potential of a traditional CD.
Hedging and Speculating
CDs can even be used in speculation and hedging strategies. With speculation, investors plan for an increase (or decrease) in the market by purchasing CDs that will increase in value under certain, expected circumstances. With hedging, investors buy CDs that work opposite other investments so they can avoid an overall loss if one part of the market declines.
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