Are CDs Good Protection For The Bear Market?

A bear market is usually an indication of a sluggish economy and a decrease in the value of overall securities. During this time, consumers tend to be pessimistic in their outlook about financial assets and?the economy as a whole. In a bear market, investors always tend to look into where their investments can be better protected, or which investment vehicles to add to their portfolios to help lessen the blow to their stocks and equity investments. Products investors commonly look into during these difficult times are more stable, income-producing debt instruments such as certificates of deposit (CD). But are CDs actually good protection for a bear market? Read on to find out.?

Tutorial: Certificates Of Deposit

What Is?a CD?
A certificate of deposit is a short- to medium-term deposit in a financial institution at a specific fixed interest rate. You are guaranteed the principal plus a fixed amount of interest at maturity, which is the end of the term. The period of the term varies, but generally you can purchase three-month, six-month, nine-month, or one- to five-year CDs. Some banks have even longer-term CDs.

CDs are considered time deposits because the purchaser agrees at the time of purchase to leave?his or her?deposit in the bank for the specific period of time. Make sure you can afford to let go of some of your money for a certain period of time before committing to a CD, because if the purchaser decides to take back?the deposit before maturity,?he or she?will be liable for a penalty, which varies from as little as a week's worth of interest to a month or six months' interest. Any fees or penalty amounts are required to be disclosed upon opening the CD account. (Build Yourself An Emergency Fund can help you ensure you won't have to liquidate your CD in a pinch.)

One major drawback to withdrawing before the term is due is that the penalty imposed could decrease not only the interest, but also the principal amount. This can happen if you purchase a 13-month CD and decide to cash it at three months. The penalty on this CD would be to pay off six months' worth of interest. Unfortunately, your CD has not even earned that amount of interest yet – and so the penalty digs into your principal amount.

Although CDs are considered low-return investments, the return is guaranteed at the specific interest rate even if market rates go lower. Typical CDs are not protected against inflation, so when shopping for a CD, try to buy one higher than the inflation rate so that you can get the most value for your money. The longer the term of the CD, the higher the interest rate will be. Although rates on CDs are not the highest in the debt instrument market, CDs earn more in interest than most money market accounts and savings accounts. (Learn more about these two deposit options in Money Market Vs. Savings Accounts.)

CDs Vs. Stocks
Stocks tend to have a higher rate of return than most securities, but this is because of the higher risk that is involved. If a?company goes through rough times, the stockholders will be the first to feel it. If the stock loses value as a result of bad management or a lack of public interest in its products or services, the value of your portfolio may be compromised. However, if the company does really well, the return you can obtain from its stock's value could be significantly higher than you would've obtained through a CD investment. (Learn more in Why Stocks Outperform Bonds.)

For the past several years, the stock market has been through turbulent ups and downs, resulting in great losses for some stockholders. CDs are one option that can help protect your investment from these times of turmoil by providing a stable income. Although the returns gained from these investments won't usually be as high as those provided by stocks, they can serve as a "cushion" to balance your portfolio and keep it afloat when the market is down in the dumps.?Because CD rates are locked in for a certain period of time, the interest rate agreed upon at the time of purchase is the interest rate that will be gained on the CD despite how poorly the market might be doing. In addition, unlike stocks and various other investment vehicles, CDs are almost always insured. (Learn how to protect your portfolio through diversification in Introduction To Diversification and Diversification: It's All About (Asset) Class.)

Guaranteed Protection
CDs are primarily a safe investment. They are guaranteed by the bank to return the principal and interest earned at maturity. The Federal Deposit Insurance Corporation?(FDIC) insures certificates of deposit for up to $250,000 for each depositor at each insured bank. This means that it will guarantee payment of your CD investment if the bank goes under. The National Credit Union Administration?(NCUA) serves the same purpose for its insured credit unions.

Knowing how much insurance you have against bank failure is essential, especially when the stock market is not faring well. It is during these times that investors tend to look deeper into insured investments. Neither the FDIC nor the NCUA insures stocks, bonds, mutual funds, life insurance, annuities or municipal securities. (For more on making sure your money is safe, read Are Your Bank Deposits Insured? and Bank Failure: Will Your Assets Be Protected?)

When searching for CD products, it is a good idea to look into how well the bank offering the CDs is doing. The FDIC has a watch list where it lists banks that might be in trouble; however, according to the FDIC, they never release ratings on the safety of financial institutions to the public. To get an idea of the how banks are performing, consumers need to visit the listings of several financial institution rating services provided on?the FDIC's website. For further info visit FDIC.gov, and review detailed credit union data at NCUA.gov.

In addition to commercial banks, thrifts and credit unions, you can also buy CDs through brokerage firms or online accounts. One drawback to buying through a brokerage account is that the broker is considered a third party to the transaction?- it is?buying the CD from a bank and selling it to you. If a bank fails, it will take longer to get your money back because the request will have to go through the brokerage rather than directly to the bank. (Read more about the role of a broker in Full-Service Brokerage Or DIY?)

CD Laddering
CD laddering can provide a flexible security blanket if done properly. Laddering helps lower your risk while increasing your return, because it allows you to continue investing in the highest-rated CDs available. The method is to use your funds to buy CDs at different maturities and interest rates. Here's how it works:

When you start a CD ladder, research the best rates, either locally or in different states. Let's say you have $5,000 in your minimal interest-bearing savings account.?Because you want to make the most of your stationary money, you decide that a CD with an interest rate of 3% looks much more appealing. Do not use money you'll need for emergencies. After you decide this is money you can afford to lock up for a period of time, go ahead and start your ladder. You can begin by buying five different CDs at various rates and maturity dates. For example, the ladder could consist of purchasing the following CDs, each at $1,000:
a one-year CD at 3% interest a two-year CD at 3.5% interest a three-year CD at 3.7% interest a four-year CD at 3.9% interest a five-year CD at 4.1% interest When the first CD matures, you will have the flexibility of either reinvesting by rolling it into a higher CD rate or cashing it out. In laddering, you will roll it over. When your CD matures, roll it over into a higher-rated five-year CD. When your second-year CD matures, roll it over into another five-year high-rated CD, and continue doing the same until you've rolled over all your initial CDs.?Because a CD in your ladder will mature each year, you will always have liquid money available. The advantage of laddering like this is that you will always get the benefit of the highest interest by rolling into the longer-term five-year CD. (For more details, read Step Up Your Income With A CD Ladder.)

Tax Consequences
Interest that you earn on your CD throughout its term is taxable. The tax on it depends on your tax bracket. According to the Internal Revenue Service?(IRS), you must report the total interest you earn on the certificate of deposit every year. Even if the interest on the CD was not paid to you directly, you will be taxed on the amount earned in that year. Interest income is considered ordinary income and taxed as such.

Conclusion
CDs are a comparatively safe investment. If they are?managed properly, they?can provide a stable income regardless of stock-market conditions. When considering the purchase of CDs or starting a CD ladder, always consider the emergency money you might need in the future. Laddering can help protect your investments by providing you with stable interest income in a bear market (or any market, for that matter), but make sure you can afford to do without that money for the term of the CD, and investigate the institution you decide to buy from.

by Ana Gonzalez Ribeiro (Contact Author | Biography)

Ana Gonzalez Ribeiro holds an MBA with honors in Finance and works as a personal finance / business writer. She has published articles in The Hispanic Outlook on Higher Education, New Mexico Woman, Spotlight on Recovery Magazine and The Loop Newsletter for College Forward. She is also a regular contributing writer specializing in business-related issues for Alaska Business Monthly. She worked for The Volunteer Center of United Way Westchester as a writer for the Youth Volunteer Guidebook 2008-2009 and served as Treasurer for the Society for Hispanic MBAs. During her spare time, she enjoys collecting stamps, reading biographies, staying up to date on business-related trends and working as a Notary Public and signing agent.

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Find Quality Investments With ROIC

Return on invested capital, or ROIC, is arguably one of the most reliable performance metrics for spotting quality investments. But in spite of its importance, the metric doesn't get the same level of interest and exposure as indicators like?the P/E or ROE ratios. Admittedly, investors can't just pull ROIC straight off a financial document like they can with better known performance ratios; calculating ROIC requires a bit more work. But for those eager to learn just how much profit and, hence, true value a company is producing, calculating the ROIC is well worth the effort.

TUTORIAL: Fundamental Analysis

Important mainly for assessing companies in industries that invest a large amount of capital - such as oil and gas players, semiconductor chip companies and even food giants - ROIC is a telling gauge for comparing the relative profitability levels of companies. For many industrial sectors, ROIC is the preferred benchmark for comparing performance. In fact, if investors were forced to rely on a sole ratio (which we do not recommend), they would be best off choosing ROIC. (There are many indicators for ranking a corporation's success. Learn more in Measuring Company Efficiency.)

The Calculations
Defined as the cash rate of return on capital that a company has invested, ROIC shows how much cash is going out of a business in relation to how much is coming in. In an nutshell, ROIC is the measure of cash-on-cash yield and the effectiveness of the company's employment of capital. The formula looks like this:

ROIC = Net Operating Profits After Tax (NOPAT) / Invested Capital

At first glance, the formula looks simple. But in the complex financial statements published by companies, generating an accurate number from the formula can be trickier than it appears. To keep things simple, start with invested capital, the formula's denominator. Representing all the cash that investors have put into the company, invested capital is derived from the assets and liabilities portions of the balance sheet as follows:

Invested Capital = Total Assets less Cash?- Short-Term Investments?- Long-Term Investments?- Non-Interest Bearing Current Liabilities
Now, investors turn to the income statement to determine the numerator, which is after-tax operating profits, or NOPAT. Sometimes NOPAT is the same as net income. For many companies, especially bigger ones, some net income comes from outside investments, in which case net income does not reflect the profitability of operating activities. Reported net income needs to be adjusted to represent operations more accurately. At the same time, the published net income figure also may include non-cash items that need to be added and subtracted from NOPAT to reflect true cash yield. For the purpose of showing all of a company's cash profits from the capital it invests, NOPAT is calculated as the following:

NOPAT = Reported Net Income?- Investment and Interest Income?- Tax Shield from Interest Expenses (effective tax rate?x interest expense)?+ Goodwill Amortization?+ Non-Recurring Costs plus Interest Expenses +?Tax Paid on Investments and Interest Income (effective tax rate x investment income)

Interpreting ROIC
If the final ROIC figure, which is expressed as a percentage, is greater than the company's working asset cost of capital, or WACC, the company is creating value for investors. The WACC represents the minimum rate of return (risk adjusted) at which a company produces value for its investors. Let's say a company produces a ROIC of 20% and has a cost of capital of 11%. That means the company has created nine cents of value for every dollar that it invests in capital. By contrast, if ROIC is less than WACC, the company is eroding value, and?investors should be putting their money elsewhere. (To fully utilize any stock metric, you must know how to read an income statement. Learn what figures to consider when performing a profitability analysis, read Find Investment Quality In The Income Statement.)

The extent to which ROIC exceeds WACC provides an extremely powerful tool for choosing investments. The P/E ratio, on the other hand, does not tell investors whether the company is producing value or how much capital the company consumes to produce its earnings. ROIC, by contrast, provides all this valuable information and more.

Moreover, ROIC helps explain why companies trade at different P/E ratios. The market demonstrates this well. From 1999 to 2003, the S&P 500 average P/E ratio fell roughly from 25 to 15, so the S&P 500?was trading at a discount to its historical multiple - does that mean the S&P 500?was oversold? Some market watchers?thought so, but ROIC-based analysis suggested otherwise. Although the P/E ratio diminished, there was also a proportional reduction in the market's ROIC. This makes a lot of sense: since 1999 companies?had had?a much harder time allocating capital to worthwhile projects.

Investors should look not only at the level of ROIC but also the trend. A falling ROIC can provide an early warning sign of a company's difficulty in choosing investment opportunities or coping with competitors. ROIC that is going up, meanwhile, strongly indicates that a company is pulling ahead of competitors or that its managers are more effectively allocating capital investments. (The return on capital employed (ROCE) is an often-overlooked financial ratio, but it's one that can accurately calculate corporate efficiency and profitability. Learn more in Spotting Profitability With ROCE.)

The Bottom Line
ROIC is a highly reliable instrument for measuring investment quality. It takes a bit of work, but, once investors start figuring out ROIC, they can begin to track company results annually and be better armed to spot quality companies before everyone else does. (Analyzing the profitability of companies is a fundamental investment skill, but it also pays to play the trends. Learn more on how to actively manage your portfolio with The Volatility Index: Reading Market Sentiment.)

by Ben McClure (Contact Author | Biography)

Ben McClure is a long-time contributor to Investopedia.com.

Ben is the director of Bay of Thermi Limited, an independent research and consulting firm that specializes in preparing early stage ventures for new investment and the marketplace. He works with a wide range of clients in the North America, Europe and Latin America. Ben was a highly-rated European equities analyst at London-based Old Mutual Securities, and led new venture development at a major technology commercialization consulting group in Canada. He started his career as writer/analyst at the Economist Group. Mr. McClure graduated from the University of Alberta's School of Business with an MBA.

Ben's hard and fast investing philosophy is that the herd is always wrong, but heck, if it pays, there's nothing wrong with being a sheep.

He lives in Thessaloniki, Greece. You can learn more about Bay of Thermi Limited at www.bayofthermi.com.

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January 7, 2011: Market Summary

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ARM'ed And Dangerous (ARMH, AAPL, MSFT, INTC, NVDA, QCOM, GOOG)

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Efficient Market Hypothesis: Is The Stock Market Efficient?

An important debate among stock market investors is whether the market is efficient?- that is, whether it reflects all the information made available to market participants at any given time. The efficient market hypothesis?(EMH) maintains that all stocks are perfectly priced according to their inherent investment properties, the knowledge of which all market participants possess equally. At first glance, it may be easy to see a number of deficiencies in the efficient market theory, created in the 1970s by Eugene Fama. At the same time, however, it's important to explore its relevancy in the modern investing environment. (For background reading, see What Is Market Efficiency?)

Tutorial: Behavioral Finance

Financial theories are subjective. In other words, there are no proven laws in finance, but rather ideas that try to explain how the market works. Here we'll take a look at where the efficient market theory has fallen short in terms of explaining the stock market's behavior.

EMH Tenets and Problems with EMH
First, the efficient market hypothesis assumes that all investors perceive all available information in precisely the same manner. The numerous methods for analyzing and?valuing stocks pose some problems for the validity of the EMH. If one investor looks for undervalued market opportunities while another investor evaluates a stock on the basis of its growth potential, these two investors will already have arrived at a different assessment of the stock's fair market value. Therefore, one argument against the EMH points out that, since investors value stocks differently, it is impossible to ascertain what a stock should be worth under an efficient market.

Secondly, under the efficient market hypothesis, no single investor is ever able to attain greater profitability than another with the same amount of invested funds: their equal possession of information means they can only achieve identical returns. But consider the wide range of investment returns attained by the entire universe of investors, investment funds and so forth. If no investor had any clear advantage over another, would there be a range of yearly returns in the mutual fund industry from significant losses to 50% profits, or more? According to the EMH, if one investor is profitable, it means the entire universe of investors is profitable. In reality, this is not necessarily the case.

Thirdly (and closely related to the second point), under the efficient market hypothesis, no investor should ever be able to beat the market, or the average annual returns that all investors and funds are able to achieve using their best efforts. (For more reading on beating the market, see the frequently asked question What does it mean when people say they "beat the market"? How do they know they've done so?) This would naturally imply, as many market experts often maintain, that the absolute best investment strategy is simply to place all of one's investment funds into an index fund, which would increase or decrease according to the overall level of corporate profitability or losses. There are, however, many examples of investors who have consistently beat the market - you need look no further than?Warren Buffett to find an example of someone who's managed to beat the averages year after year. (To learn more about Warren Buffett and his style of investing, see?Warren Buffett: How He Does It?and The Greatest Investors.)

Qualifying the EMH
Eugene Fama never imagined that his efficient market would be 100% efficient all the time. Of course, it's impossible for the market to attain full efficiency all the time, as it takes time for stock prices to respond to new information released into the investment community. The efficient hypothesis, however, does not give a strict definition of how much time prices need to revert to fair value. Moreover, under an efficient market, random events are entirely acceptable but will always be ironed out as prices revert to the norm.

It is important to ask, however, whether EMH undermines itself in its allowance for random occurrences or environmental eventualities. There is no doubt that such eventualities must be considered under market efficiency but, by definition, true efficiency accounts for those factors immediately. In other words, prices should respond nearly instantaneously with the release of new information that can be expected to affect a stock's investment characteristics. So, if the EMH allows for inefficiencies, it may have to admit that absolute market efficiency is impossible.

Increasing Market Efficiency?
Although it is relatively easy to pour cold water on the efficient market hypothesis, its relevance may actually be growing. With the rise of computerized systems to analyze stock investments, trades and corporations, investments are becoming increasingly automated on the basis of strict mathematical or fundamental analytical methods. Given the right power and speed, some computers can immediately process any and all available information, and even translate such analysis into an immediate trade execution.

Despite the increasing use of computers, however, most decision-making is still done by human beings and is therefore subject to human error. Even at an institutional level, the use of analytical machines is anything but universal. While the success of stock market investing is based mostly on the skill of individual or institutional investors, people will continually search for the surefire method of achieving greater returns than the market averages.

Conclusion
It's safe to say the market is not going to achieve perfect efficiency anytime soon. For greater efficiency to occur, the following criteria must be met: (1) universal access to high-speed and advanced systems of pricing analysis, (2) a universally accepted analysis system of pricing stocks, (3) an absolute absence of human emotion in investment decision-making, (4) the willingness of all investors to accept that their returns or losses will be exactly identical to all other market participants. It is hard to?imagine even one of these criteria of market efficiency ever being met.

by Jason Van Bergen (Contact Author | Biography)

Rate this Article: ?Your Rating: ?? Overall Rating: Vote Now! The security that offers the best protection against purchasing power risk or inflation is which of the following? (view answer)A formula timing plan which consists of periodic purchases of a fixed dollar amount of an investment company regardless of price is known as: (view answer)Is there a buy-and-hold strategy in forex, or is the only way to make money by trading? (view answer)How do you lose money in the Forex market? (view answer)What's the difference between weighted average accounting and FIFO/LILO accounting methods? (view answer)What effect did the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 have on debtors? (view answer)

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