Certificate of Deposit (CD)

A Certificate of Deposit (CD) is a straightforward savings product offered by banks and credit unions that's about as safe as it gets. Think of it as a special savings account with a commitment. You agree to leave a specific amount of money with the bank for a set period—known as the “term”—which can range from a few months to several years. In return for your commitment, the bank pays you a fixed interest rate, which is typically higher than what you'd get from a regular savings account. This makes your return completely predictable. In the United States, most CDs are insured by the FDIC up to $250,000 per depositor, per insured bank, making them a fortress for your cash. Similar deposit guarantee schemes exist across Europe, providing a similar level of security. While not a flashy investment, the CD's simplicity and safety make it an essential tool for any prudent investor, especially those practicing value investing.

It's beautifully simple. You deposit a lump sum (the principal) into a CD. The bank locks in the interest rate and the maturity date (the day your term ends). For example, you might put $10,000 into a 1-year CD with a 5% Annual Percentage Yield (APY). At the end of the year, you'll get your original $10,000 back plus $500 in interest. The catch? If you need your money before the maturity date, you'll likely face an early withdrawal penalty, which is often equal to several months' worth of interest. So, it's a deal: you promise not to touch the money, and the bank promises you a guaranteed return.

A value investor's favorite four-letter word isn't “risk”—it's “cash.” Having capital ready to deploy is critical, and a CD plays a key role here.

Value investors, like Warren Buffett, often keep a significant amount of cash—or “dry powder“—on hand, waiting patiently for the market to serve up a bargain. Letting this cash sit in a zero-interest checking account is a waste. A CD provides a safe, government-insured vehicle to park that cash, allowing it to earn a respectable return while you hunt for your next great investment. It keeps your powder dry and working for you simultaneously.

CDs are safe, but they aren't without their drawbacks. It's crucial to weigh the good against the bad.

• Pros:
  • Safety: Your principal is protected, and in most cases, insured by the government. Sleep-well-at-night money.
  • Predictability: The fixed interest rate means you know exactly how much you will earn. No surprises.
  • Better Yields: They generally offer higher interest rates than standard savings or checking accounts.
• Cons:
  • Inflation Risk: If the rate of inflation rises above your CD's interest rate, your money is actually losing purchasing power.
  • Opportunity Cost: Your money is locked up. If a fantastic stock opportunity appears, you can't access your cash without paying a penalty.
  • Interest Rate Risk: If interest rates in the broader economy go up, you're stuck earning your CD's lower rate until it matures.

Not all CDs are created equal. Here are a few common flavors:

• Traditional CD: The plain-vanilla version. Fixed term, fixed rate, penalty for early withdrawal. Simple and effective.
• No-Penalty CD: Also known as a liquid CD. It allows you to withdraw your funds before the maturity date without a penalty. The trade-off is usually a lower interest rate compared to a traditional CD.
• Brokered CD: These are CDs that you purchase through a brokerage firm. They can be bought and sold on a secondary market before they mature, which provides liquidity without an early withdrawal penalty. However, their value on the secondary market can fluctuate, so you could lose principal if you sell before maturity.

To combat the downsides of tying up your money, many savvy savers use a strategy called the ”CD ladder”. It’s a brilliant way to balance the need for higher yields with the need for access to your cash.

Instead of putting, say, $25,000 into a single 5-year CD, you build a ladder by splitting the money up:

• Put $5,000 into a 1-year CD.
• Put $5,000 into a 2-year CD.
• Put $5,000 into a 3-year CD.
• Put $5,000 into a 4-year CD.
• Put $5,000 into a 5-year CD.

After the first year, your 1-year CD matures. You can then reinvest that money into a new 5-year CD to get the best available long-term rate. The next year, your original 2-year CD matures, and you do the same. After a few years, you'll have a “rung” of your ladder maturing every single year. This gives you regular access to a portion of your cash while allowing the bulk of your money to earn the higher rates typically associated with long-term CDs. It’s a fantastic way to manage both interest rate risk and your personal liquidity needs.