Stashed deep in my basement is a box of old DVDs that my mother had made many years ago which were formally home videos on VHS. On one of these DVDs is a video of my 8th birthday party. I will preface the story here by admitting that what I am about to share is not my finest moment. In the video I can be seen opening what looks like a very large and alluring birthday present. With my eyes opened wide, I rip the wrapping paper off and open the box. Inside are several articles of clothing. I then proceed to throw the clothes over my shoulder in disgust and look around for another present. In the background my mother can be heard sternly saying “NATHAN LEE BEAUVAIS!”.
We’ve all been there: we get excited about what appears to be a great opportunity or option, only to be disappointed after we fully comprehend the details. Sometimes it’s a dinner menu option, other times it’s a too-good-to-be-true price on a new car that turns out to be a lemon. Recently I have found many people experiencing this phenomenon when shopping for fixed/guaranteed investments.
In January of 2021, the 2-year Treasury was paying a paltry rate of 0.15%. Fast forward a little more than two years later and that rate is now north of 5%. Suddenly short-term CDs are paying a rate not seen in almost two decades. Money Market funds are also paying what appear to be a very generous rate of interest. But it’s important to remember why theses rates have come up so briskly: inflation.
Which would you rather have: a return on your investments of 8% where your cost of living is increasing at 5%, or a ROI of 6% where your cost of living is increasing at 2%? The real return in these two scenarios is 3% and 4% respectively. Getting a guaranteed rate of return of 4 or 5% sounds great - and it would be if inflation didn’t exist. The Consumer Price Index, which measures inflation in the economy, came in at almost 4% for the month of August. That’s nearly double the average from 2000-2020.
Before investors lock in to a guaranteed-rate product like a CD or fixed annuity, they need to ask themselves what real rate of return they need to achieve their goals. These types of products eliminate the risk of variable investments returns but they open us up to the possibility of inflation risk. It is important to remember that there is no riskless option. There are only different types of risk, and we must choose which ones to expose ourselves to carefully.