Investors who are seeking regular returns and a promise of the return of principal often choose to include fixed-income investments, such as certificates of deposit (CDs), in their portfolios. Conservative fixed-income investments, particularly government securities and federally insured CDs, are generally considered less volatile than other investment vehicles, such as common stock and, as a result, they tend to provide lower rates of return. One technique commonly used to balance the return and risk of CDs with an investor’s time horizon is laddering—a method of maintaining a series of fixed-interest investments with different maturities.
How It Works
With a “laddered” portfolio, CDs come due in staggered intervals, at which time they may be cashed or reinvested. Because investments with shorter maturities generally have lower interest rates, laddering looks to provide an investor with the financial benefits of long-term interest rates, but the flexibility of shorter-term maturities.
Each CD acts like a rung on a ladder, so that rather taking one big step—such as investing in a single, long-term savings vehicle—you can take smaller steps toward long-term savings goals. Furthermore, stepped maturity dates may provide liquidity options that enable you to hold a security until its date of maturity, which may protect against early withdrawal penalties. For illustrative purposes, consider the following hypothetical example, which assumes no federal taxes or fluctuation in interest rates and does not represent the performance of any particular investment.
Alice Blackwell wants to invest part of her savings in a portfolio that will provide her access to her funds in the event she goes to graduate school. She chooses to deposit $10,000 into a laddered CD Portfolio and reinvest the principal until she needs the funds. To start, Alice splits her principal between five CDs, each with different maturities and interest rates. Every year during the next five years, one of her CDs will mature.
Principal Maturity Interest Total Year Due
$2,000 1 year 2.5% $2,050 2020
$2,000 2 years 3.5% $2,142 2021
$2,000 3 years 4.5% $2,282 2022
$2,000 4 years 5.0% $2,431 2023
$2,000 5 years 5.5% $2,614 2024
Upon maturity of the one-year CD, Alice pockets the interest earned and purchases a five-year CD with a higher interest rate that will mature in 2025. When her two-year CD matures, she takes the earnings as income and, with the original principal, purchases another higher yielding five-year CD, which will mature in 2026. While Alice is buying CDs with longer maturities and larger returns, one of her CDs will still reach maturity every year, providing her either access to her money, or the opportunity to reinvest.
It is important to plan your investment strategies in light of your long-term goals. Laddering offers fixed-income investors a way to manage certain risks and add liquidity to their portfolios.