I just received an unexpected but much appreciated bequest of $30,000 that I'd like to invest for about 5 years until I'm ready to start my own small business. Considering the recent performance of my 401(k) plan, I'm loath to put this windfall into stocks. What would you suggest?
Dear Risk Averse,
As the concerned owner of a 401(k) currently on life support, I certainly appreciate your aversion. At the risk of sounding like an LOL (little old lady) investor, have you considered Certificates of Deposit (CDs)? With a five-year time horizon such as yours, you can lower your risks and probably increase your ultimate rewards by using a strategy known as "laddering" CDs.
A CD is really just a loan you make to a bank at an agreed upon rate of interest for a specific period of time. You can build a "ladder" out of these instruments by going to a bank with your $30,000 and buying, for example, five $6,000 CDs with increasing expiration dates. CD-A will be $6,000 at x percent for one year; CD-B will be $6,000 at x percent for two years. . .and so on up to five. The longer the term, the more interest you'll get. And you can hedge even more by doing this in six-month, three-month or sometimes even 1-month increments, depending on what your bank or broker is offering at the time.
When the first rung (the one-year CD we called A) of the ladder expires, you can roll it over into a five-year CD, adding a rung to the top of the ladder. This way you haven't got all your money tied up at the same rate and you're never more than a year away from access to at least part of your nest egg.
Laddering is kind of like dollar cost averaging in stocks or mutual fund equities. And this technique has added advantages such as Federal Deposit Insurance (FDIC) protection, low or no brokerage fees and frequent compounding of interest.
As of this writing, the interest rate of a standard 6-month CD is roughly 0.6 percent and a five-year CD is approximately 1.6 percent. (Check BankRate.com for current rates.) But before you turn your nose up at these paltry returns, consider that stock market returns dipped significantly, and many of our 401(k)s took a beating just a couple years back. Recession relapse rumors abound. Keep in mind that these lowly CDs, at least up to $250,000, being FDIC insured, have no risk. Can the Dow or the S and P stocks make that claim?
The bottom line: Laddering is a tried and true strategy where our ultimate objective is not to earn high rates but to avoid low rates over long periods of time. Check out this handy calculator.