Monday, April 11, 2011

Bank Certificates Trade Performance for Certainty

Bank Certificates Trade Performance for Certainty
- By Dan Danford, MBA, CRSP®

A fellow visited St. Joseph last January for a job interview. When he arrived back home, he complained to his wife, “I could never live there. It’s always cold and blustery and there wasn’t a speck of green anywhere.” A different man (in several ways) came home from a July conference. “Hot and humid,” he explained, “why, I couldn’t bear that heat without a year-round air conditioner.”

Both men took a limited look at Missouri weather and drew mistaken conclusions. Actually, each explanation contains an element of truth, but either conclusion by itself is completely and totally wrong. By their faulty reasoning, everything depends on when you visit!

I sometimes hear a similar “bank rate” argument; it goes like this: “I could put my money in the bank and make as much as you made me through Family Investment Center.” Or, another way it’s said is “a bank paying two percent a year would have made me more money.” There may be some truth to these statements, but – like our example above - the logic is dangerously flawed.

Here’s why: Banks offer a sure low rate instead of a possible higher one. If you think about it, banks agree to pay two (or three, or four) percent only because they’re certain they can invest the deposits to earn more. Only, with the bank, they get to keep the difference as profit! I spent fifteen years in banking, and I can assure you this is true.

They know something that many customers don’t: guaranteed bank rates are short-term (usually forty-eight months or less), while most longer investments grow at a steeper pace. In essence, banks pay customers a guaranteed low rate, while using the deposits for more rewarding longer-term investments.

Bank accounts and certificates don’t fluctuate in value because their principal and interest is guaranteed. Balances grow at a very slow predictable rate. Common stocks or longer-term government bonds change value on a daily basis, because there’s a vibrant market for them.
In order to attract investors, these longer-term investments must offer higher potential rewards - it’s a basic foundation of economics. Generally, things that fluctuate will reward long-term investors by compounding at a higher rate.

So, high quality client portfolios containing stocks, bonds, or other kinds of investments will surely endure some slower times. Because of these fluctuations, there will always be periods of time – usually short-term - when bank deposits outperform them.

Banks look best when other investments fluctuate downward, and worst when portfolios explode upwards (customers rarely complain about this, though!). Like our earlier weather watchers, though, neither of these circumstances is really representative of long-term performance.

In most types of solid investing, there will be limited periods where a bank would have done better. That’s not the whole story, though, and bank customers trade performance for certainty. It’s an expensive choice to make.

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