Many people would benefit from investing in a few CDs for their financial portfolio, and yet not many have them. A certificate of deposit makes for an ideal investment as it consistently generates a high yield return if you know how to invest in them. Many banks offer better CD rates the longer your investment term. Discover more about the advantages and disadvantages of this type of investment.
Advantages of CDs
Finding the best CD rates can greatly improve your investment portfolio’s worth. If your money is mainly in a savings account, you’re earning little to no interest at all. If you’re invested in stocks or real estate, history shows that you can lose money at a moment’s notice. Risky investments have opportunities for higher gains but can also cost you in the short term.
As mentioned, one of the best advantages of investing in a certificate of deposit account is that it generates consistent returns. In any portfolio, you’ll want to balance between investments that generate small but steady returns with high risk investments that could potentially yield high returns. That way if your risky investments start losing money, you’ll be slightly hedged with CD rates that are still making you money. CDs are also a set and forget type of investment. Once you sign up for a CD account, you simply have to wait for the maturity date and collect your interest to invest in the next CD.
Not all investment types are perfect for everyone however, so you’ll have to weigh some of the potential disadvantages.
Disadvantages of CDs
One of the biggest problems with CDs is that you will not have access to your funds for a predetermined amount of time that you decide on. If you withdraw your initial deposit, you would be charged a penalty fee. Fortunately, you can prevent this from ever occurring by only investing money that you will not need in the near future. Establishing and emergency fund and making sure all debt is paid off before you invest will ensure that you will not ever need to touch the initial deposit on your CD account.
Every financial portfolio can benefit from a certificate of deposit, so if you are not invested in them start researching for the best CD rates today.
A perfect market is defined by the following assumptions:
No Differences in Information Everyone holds the same opinion. How can this assumption be violated? Here is one example. If your bank believes that there is a 50% chance that you will go bankrupt and default, and you believe that there is only a 0.1% chance, then your bank will lend you money only if you pay a much higher expected interest rate than it will pay you if you deposited your money with it.
This is why our perfect markets assumptions includes one that everyone has the same information and agrees on what it means. (It does not mean that there is no uncertainty, however. The important point in a perfect market is that everyone interprets the uncertainty identically.)
A Deep Market You can easily find a buyer or a seller. How could this assumption be violated? Say there is only one bank that you can do business with. This bank will exploit its monopoly power. It will charge you a higher interest rate if you want to borrow money from it than it will pay you if you want to deposit your money with it—and you will have no good alternative. (There is one nitpick qualification: if a project is worth more if it is owned or financed by a particular type—e.g., if a golf range is owned by a golf pro—then there must be a large number of this type of owner.)
This is why our perfect markets assumptions includes one that there are infinitely many buyers and sellers.
No Transaction Costs You can trade without paying any transaction costs. How can this assumption be violated? If it costs $1,000 to process the paperwork involved in a loan, you will incur this cost only if you need to borrow, but not if you want to save. This will make your effective borrowing interest rate higher than your effective savings interest rate. This is why our perfect markets assumptions includes one that there are no transaction costs.
No Taxes There are no tax advantages or disadvantages to buying or selling securities. Specifically, there are no asymmetric tax treatments to the seller divesting or to the buyer purchasing. How can this be violated? If you have to pay taxes on interest earned, but cannot deduct taxes on interest paid, your de facto savings rate will be lower than your borrowing rate.
This is why our perfect markets assumptions includes one that there are no taxes. We will soon tackle each of these issues in detail. However, the effect of violating any of these assumptions is really the same. Any violation that breaks the equality between the borrowing and the savings rate also breaks the link between value and one unique price (or cost). In fact, the value of a project may not even have meaning in imperfect markets—a project may not have one unique value, but any from among a range of possible values.