If you have some extra cash on hand that you are looking to invest, certificates of deposit (CDs) and stocks are among your options. There are major differences between the two. Those include the level of risk you are exposed to (stocks are riskier), the ideal length of your investment (stocks are for the long term), flexibility (you can't cash in a CD early without a hefty penalty), and returns (in the long run, stocks are likely to give you higher returns). In this article, we'll take you through these differences in detail.
- Certificates of deposit (CDs) and stocks differ in some significant ways.
- CDs are low-risk, relatively low-return financial vehicles that are best suited for short-term investors or the risk-averse.
- Stocks, in comparison, offer higher potential returns and greater risk and are best suited for long-term investors who can ride out price fluctuations.
CDs vs. Stocks: The Key Differences
When you buy a certificate of deposit, you agree to leave your money with that bank, credit union, or other financial institution for a set period of time. In exchange, the financial institution promises to pay you a set interest rate on your money—one that is typically higher than other types of savings accounts. The downside is that CDs aren't liquid; you have to keep your money in the CD for the whole term you've agreed to, or you'll pay hefty penalties.
This makes CDs suitable for certain kinds of investors, or those looking to meet specific financial goals. For example, CDs can be a good choice for people who have some spare cash they don't need now but expect to need in the near future. That fmight be because they are planning to buy a house or take a dream vacation in a few years' time. CDs are also well suited for very risk-averse investors who just don't want to take their chances with the stock market.
On the other hand, investors who are comfortable with a certain amount of risk may find stocks to be considerably more rewarding.
Here is a deeper look at the fundamental differences between CDs and stocks.
CDs offer a guaranteed interest rate, no matter what happens to the economy or the financial markets. Most CDs sold by banks and credit unions are also insured by the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA) up to certain dollar limits. This makes them one of the lowest-risk investments available, especially over the short term.
If you are saving for a big, planned purchase in a couple of years, you could put your money in the stock market, but you'd be taking the risk that your stocks could be way down in value when you need to get your money out. However, stocks are better for long-term investors who have time to ride out short-term losses.
Of course, you could be a risk-averse, long-term investor who just doesn't trust the stock market, and that's fine as well. In that case, you might look to long-term CDs as the highest-paying almost-certain investment available. However, you'll want to be aware of inflation risk, which could reduce the purchasing power of your money over time.
Length of Investment
The second main difference between stocks and CDs is a consequence of the first. Because of the inherent volatility of the stock market, stocks are best suited for long-term investors with the luxury of time. Any short-term drop in the stock market—or even a major crisis—can be irrelevant if your investment horizon is measured in decades.
CDs are generally best for short- to medium-term investments: that is, of one to five years. But once again, there is nothing wrong with using CDs as a long-term investment tool if you want to build a very low-risk portfolio. You might just have to put up with low returns.
Brokered CDs, sold by brokerage firms and independent salespeople, may not offer the same insurance protection as those sold by banks and credit unions. So before buying one, be sure to ask.
There are two main downsides to CDs. One is their lack of liquidity. You have to leave your money in the CD for the term you've agreed to (unless you have a liquid CD, a no-penalty CD, or some other exotic type of CD). Otherwise, you'll probably have to pay sizable early withdrawal penalties that could wipe out your returns.
In contrast, stocks are relatively flexible. You can buy and sell stocks as often as you wish and cash them out whenever you like. You may have to pay a fee for doing so, but it will generally be less than the penalties associated with early withdrawals from CDs.
This flexibility might be attractive if you need emergency access to your money. But continue to keep in mind that stocks are inherently volatile. You can pull your money out of stocks at any time, but there is no guarantee that they will be worth what you paid for them.
The second downside to CDs is the relatively low returns they offer. This is a feature they share with other types of low-risk investments.
Of course, the rate of return offered by stocks is very variable and not guaranteed in any way. Even a relatively low-risk portfolio might lose much of its value over the course of a few weeks or months, and a serious economic slump or market crash could adversely affect the value of your portfolio for an even longer period. But over the course of decades, the returns provided by well-diversified stock portfolios should exceed those of CDs.
Are CDs Better Than Stocks?
It depends. CDs can be useful for people looking to invest their money for a few months or years or for building very low-risk portfolios. In general, though, well-diversified stock portfolios will offer higher returns over the long term.
Are CDs Safer Than Stocks?
Yes, much safer. When you purchase a CD, the bank or credit union will guarantee your interest rate. Most CDs are also insured up to certain limits by either the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA). By contrast, there is no guarantee that any individual stock, or even a diversified portfolio of stocks, will increase in value over time. In a worst-case scenario, a particular stock can also become worthless.
Can CDs Decrease in Value?
It's very unlikely, especially if the CD is insured by the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Administration (NCUA) and is within their coverage limits. However, your money can lose purchasing power if the inflation rate is higher than your CD's interest rate. This is a particular risk with long-term CDs.
The Bottom Line
CDs are low-risk, relatively low-return investments best suited for people looking for a place to put their money for a short period of time or those who want to avoid any possibility of loss. Stocks, in contrast, are higher-risk investments with potentially higher returns, making them better suited for long-term investors who can ride out price fluctuations.