There has been a massive amount of media coverage this week of stocks like GameStock that have surged to unbelievable price levels as small traders organized via Reddit attempt to profit from short selling done by hedge funds. Early in the week, it appeared the small traders were winning, but then on Wednesday, brokerage firms like Robinhood restricted access to these stocks. Almost everyone seems to be alleging that these brokerage firms have colluded with the hedge funds so that the hedge funds continue to win at the expense of the small traders.
How does this relate to deposits?
First, it doesn’t help the image of the stock market. Day traders who push stock prices to extremely overvalued prices give an impression that the stock market is just a casino. Hedge funds appearing to collude with brokerage firms give an impression that the casino is rigged against the average traders.
If you think the stock market is a rigged casino, you might think it’s safer to depend on just deposit accounts for your investments. Unfortunately, this has risks which I describe below.
Instead of thinking that the stock market is a rigged casino, people may think that the average trader has a chance to win big. The publicity of small traders making a fortune from these stocks may be encouraging more stock buying. Perhaps more of those government stimulus checks will end up in the stock market than in deposit accounts. A rising stock market helps deposit rates since it entices people to move money from their bank accounts into the stock market.
On the other hand, a falling stock market puts downward pressure on deposit rates. That’s especially the case when the market crashes and people start moving money from stocks to cash. Also, when the stock market crashes, the financial system and the economy will often take a hit. Bond yields fall and the Fed will pledge zero rates for even a longer period of time.
One worry from this week’s stock market news is that it could be an early sign of market troubles ahead. As this CNBC opinion piece warned, “GameStop is like past bubbles and investors should exit before it bursts like the others.”
A more worrisome bubble is the one that the Fed and other central banks may be creating. This article from market strategist Sven Henrich describes this bubble and the disturbing risks it poses to the markets and the economy. This bubble could have more of an effect on long-term investors.
Long-term investors don’t day trade stocks. Instead, long-term investors build a well-diversified portfolio of stocks and bonds. One strategy that is favored by many experts is a simple index fund strategy in which the investor buys a small number of well-diversified and low-cost index funds that are held for the long term (see this Bogleheads investment philosophy document for the foundation of this strategy.) Typically, financial advisors will recommend a balanced portfolio that includes bonds. So in addition to stock mutual funds or ETFs, an investor would include well-diversified and low-cost bond index funds as part of one’s portfolio. The generally accepted strategy would be to regularly rebalance your portfolio to maintain a certain percentage of stocks and a certain percentage of bonds. As you age, you slowly grow your percentage of bonds and reduce your percentage of stocks.
Where CDs may fit in a long-term investor portfolio
A small percentage of financial advisors suggest including CDs with your bond mutual funds and ETFs for that fixed-income part of your portfolio. Direct CDs that you get directly from banks and credit unions don’t have interest rate risks since their value won’t fall when interest rates rise. Allan Roth described his portfolio in this AARP article. In addition to index funds, a sizable amount of Allan Roth’s portfolio is in CDs:
I’ve written for over a decade about going directly to banks and credit unions to buy FDIC- and NCUA-insured certificates of deposits that pay more than high-quality U.S. government bonds and offer minimal early withdrawal penalties.
The risk with stocks
Unfortunately, the economy and the Fed are making it harder to include CDs and bonds as a large percentage of one’s portfolio. The zero interest rate environment has caused bond yields and CD rates to plummet, and the signs point to this lasting for many years to come. This is pressuring people to increase the percentage of stocks in their portfolios and it could be adding to the asset bubble that Sven Henrich described.
What if stocks crash with the S&P Index falling to disturbingly low levels? Will we see something like what happened in Japan when the Nikkei crashed in 1989, and after more than 30 years, the Nikkei Index has still not reached its 1989 high?
One thing that can reduce this risk is global diversification. Including mutual funds and ETFs with foreign stocks can reduce risks that are specific to one nation. However, the US is such a large part of the world economy that global diversification may not significantly reduce this risk. Also, the Fed isn’t the only central bank that has been pushing low rates and asset purchases.
The risk with deposit accounts
If you stay within FDIC-insured and NCUA-insured levels, at least you can maintain a high level of confidence of not losing your money. Of course, there will always be the risk of losing out to inflation. That’s the main risk of deposit accounts.
This MarketWatch article provides a short review of investments that can provide a hedge against inflation. These include gold, bitcoin, stocks, TIPS and I Bonds. Maxing out on I Bonds each year is a simple way to provide a little hedge against inflation. In addition to choosing investments to hedge against inflation, you can take other steps if high inflation hits. Several good tips are in this AARP article from Allan Roth, “8 Steps to Make Sure You Don't Go Broke in Retirement.”
Investing when there are risks of high inflation and asset bubbles?
In his press conference last Wednesday, Fed Chair Powell talked in depth about why the Fed isn’t worried about high inflation. According to the Fed Chair, “We know what to do with higher inflation. Should the need arise, we would have those tools, and we don’t expect to see that at all.”
Fed Chair Powell also tried to dispel worries that the Fed is creating asset bubbles:
The connection between low interest rates and asset values is probably something not as tight as people think because a lot of different factors are driving asset prices at any given time.
Many don’t have that much confidence in the Fed. As Sven Henrich warned in his article, “the Fed hasn’t been able to control anything in recent years.”
When you factor in inflation, no investments are without risks. The best you can do is to minimize risk with diversification and by sticking to investments that you understand and that allow you to sleep at night. Including some bank and credit union CDs, savings accounts and reward checking accounts in your portfolio can help.