I love a financial panic, don't you? Yeah, there's nothing like the sight of an angry mob breaking down the doors to the bank to put a little drama in your life - like something out of those old Hollywood movies. The most amazing thing to me, though, isn't the lines of people, it's that there are actually people in this country who still have any money left in the bank. Geez, after gassing up the car and paying for my groceries, I'm pretty well tapped out.
And what's even more amazing is that in this new electronic age there are still people who go to the bank at all. Maybe it's just me but I always assumed that pretty much everybody does their banking online these days. Well, maybe not. Apparently a lot of people are doing their banking the old fashioned way - they get in their cars and drive to the bank and fill out their little deposit/withdrawal slips and go stand in line - just like grandma and grandpa used to do.
That's so weird.
You know, people, you don't have to do that anymore. They have these things called ATM's now, and direct deposit and the internet and all kinds of neat stuff. If you want to take your money out of one bank and move it to another, you can even do this thing called an ACH transfer and the banks take care of it all electronically. It's so much easier than grabbing a baseball bat and running down to the bank to demand your money back.
Anyway, I must be out of step because I have at least a half dozen bank accounts and I haven't set foot in a bank in years. No, that's not true. I did have to go into my Credit Union to open a checking account, but then Credit Unions always seem to be a bit behind when it comes to new technologies. Other than that I don't think I'd know what the inside of a bank looks like. Do they still give you cookies? Do they still run passbooks through big noissy machines that stamp your balance on little pink pages?
I just did a google search and according to a 2006 study the percentage of online banking customers back in 2005 was around 40%. Hmm, I guess I was wrong. It looks like most people do still do their banking the old fashioned way. Go figure. Maybe people don't know about this thing called electronic banking. You know maybe...just maybe...this would be an opportunity for me to actually post something useful to this blog. Wouldn't that be something? No guarantees mind you, but why not give it a try.
Let me start by telling you about this guy I saw on the news. He had a CD with Indymac Bank for around $220,000, and when Indymac went belly up he was only able to recover about $170,000 of his deposit. He may get more in the future, but that's all he's gotten so far. Clearly, that guy was doing his banking under the old "sit down at the desk, open an account, get your little book stamped (and ask if they have any cookies)" model. Mind you, there's no law that says you can't do it that way, but you see what can happen.
Nowadays, you have other options. If he had come to me with his money and sought my advice I would have sold him some life insurance. No, no, I'm just kidding. I would have shown him how CD investing works in the modern world.
His first mistake, you see, was going to the bank. I figure he saw an Indymac ad in the paper advertising some ridiculously high CD rate and decided to take all his money and go for it. That's perfectly understandable, particularly if you've looked at some of the pitiful rates that savings and money market accounts are paying these days. However, what he should have done instead of going down to the bank is go online.
Once online he could have gone to a website like bankrate.com and compared Indymac's rates to some other CD rates currently on market, and he could have even bought most of them right there over the internet if he wanted to. Yep, he could have done that, but then he might have ended up in the same fix he's in now. Unfortunately, just because a CD is listed on bankrate.com, that doesn't mean the issuing bank is any more fiscally sound that Indymac was.
With $220k to invest, what I would have recommended instead is that he ladder his CD's, and the easiest way I've found to do that is with an online brokerage account. Most, if not all, online brokerage accounts can be set up online, and in many cases can be linked directly to your bank account, making it easy to transfer cash back and forth between the two. Once you have set up and funded your account, then CD laddering is as simple as it gets.
Maybe I should explain laddering. The whole idea behind CD laddering is to spread your interest rate risk over a group of CD's, trading some upside (and downside) potential for a better average return over time. For example, suppose you put $220,000 in a 12 month CD paying 3.8%. That's great, but let's say that a couple of months after your purchase interest rates start to rise. Now instead of paying 3.8%, newly issued 12 month CD's are paying 4.0%. Oops. By locking yourself in to that one CD, your going to miss out on an extra .02% of interest for the next 10 months until your CD matures. Then let's say that interest rates continue to rise and a couple of months later 12 month CD's are paying 4.2%. Now you're really starting to feel screwed.
If instead of putting all of your $220k into that one CD, though, suppose you laddered your money instead. That is, instead of buying 1 CD you buy 4 CD's of varying lengths. For example, you put $55k into a 3 month CD paying 2.5%, another $55k into a 6 month CD paying 2.9%, another $55k into a 9 month CD paying 3.4%, and finally the final $55k into the 12 month CD paying 3.8%. Obviously, your not going to make as much money laddering as you would by putting all your money into one 12 month CD, but now what happens if interest rates start to rise.
Well, in 3 months the first CD matures so you invest the proceeds from that CD into a new 12 month CD paying 4.0%. In another 3 months the second CD matures and you invest the proceeds from that into a 12 month CD paying 4.2%. In another 3 months the third CD matures and you invest it into a 12 month CD, and in another 3 months the fourth CD matures and you invest it in another 12 month CD as well. As you can see, now instead of having all of your eggs in one basket, you've got a situation where every 3 months one of your CD matures and gets reinvested, allowing you to take advantage of rising interest rates.
Of course, interest rates can also fall, but by laddering you insure that as they fall at least some part of your investment is either at or above the current rate. That's the whole idea behind laddering, and this is just one simple example of how it can be done. By averaging your purchases over time, you guard against fluctuation.
So why do you need an online brokerage account to do that? You don't, but brokerage accounts make it much easier. I'll use Charles Schwab as an example, since that's the broker I use. You might not know it but Schwab isn't just about stocks and bonds, and in fact has a whole section of their website dedicated to CD's ( I'm pretty sure that Ameritrade and Etrade and all the others do as well). If you go to Schwab's CD page you'll see that they offer a list of CD's of different interest rates and maturities offered for sale.
To set up a ladder, all you do is search the maturity your looking for, compare the rates from the different banks, and press the "buy" button. There are no transaction costs involved because Schwab has an agreement with certain banks and the banks pay all the fees. In the above example, you could buy a 3 month CD from Bank A, a 6 month CD from Bank B, a 9 month CD from bank C, and a 12 month CD from bank D, which not only spreads out your interest rate risk but also keeps all your money fully FDIC insured if the individual CD's are with different banks and under the $100k limit.
So you see, there was no reason for that gentleman to lose the money he did. He could have gone online and laddered his CD's and saved himself a lot of grief. It's all about risk management, and I bet you there are a lot of people out there making all sorts of fancy trades who don't have a clue about simple cash investing. It's certainly not very sexy and your not going to sell a lot of copies of Money Magazine by putting CD Laddering on the cover, but with the way things are today and everybody ducking for cover it might not hurt to learn a little about the less glamorous side of investing.
Hope that was useful.
No comments:
Post a Comment