After the recent market slip – which was particularly unforgiving to emerging markets and other hot areas – we received a great question from a subscriber that some of you may also be asking:

After suffering through the recent decline and having previously reviewed your comments regarding the future prospects for both stocks and bonds I am wondering why the 5.2% and higher yields in CDs with no risk would not have a large place in at least the Safety through Growth portfolios.

Why bother with stocks and stock funds if the outlook for them is weak and CDs are offering decent yields?

And here's our answer:

While we have nothing against shopping around for a high-yield CD, we think you can do better with low-fee bond funds most of the time. 

In fact, our general forecast for stocks coupled with our risk aversion in our lower risk portfolios is why we own bond funds.

CDs offer FDIC-guaranteed returns. Money market mutual funds do not, but for all practical purposes they are about as risk-free as CDs because the funds invest largely in U.S. Government debt, and the government is not going to default on their short-term debt obligations. If they do, chances are they won’t be able to back up any bank deposits anyway.

Money market funds tend to have yields slightly lower than bank CDs. The plus side is you can sell a money market fund whenever you want for no penalty (you can even get check writing privileges). If interest rates climb, your money market will start paying higher rates – unlike your CD, which is fixed. In practice, CDs are better investments than money market funds when you don’t need your money during the term of the CD (and interest rates go down or stay flat after you buy the CD). In other scenarios you will generally do better in low-fee money market funds. 

For comparison, today the Vanguard Prime Money Market fund yields 4.73%. The average CD yields about 4.78%. The highest yielding CD pays about 5.3%.

We tend to use short-term bond funds instead of money market funds in our portfolios. These funds yield more than money market funds (barely so in today’s flat rate environment), but have slightly higher risk – both interest rate risk and default risk. Today Vanguard Short-Term Investment-Grade Fund Investor Shares (VFSTX) yields about 4.94%.

In most environments you’ll do as well or better in a low-fee, short-term bond fund than a bank CD – with liquidity. Looking back over calendar year returns, only about 1/3 of the time will rolling your money over and over into new, shorter-term CDs outperform the Vanguard fund noted above.

The liquidity issue is key as we change our allocations to stocks based on market movements and fund investor behavior – we don’t want to be stuck in CDs if opportunity knocks.

Why buy stocks at all with a low expected return?

First, at the present we are not fully invested in stocks in any of our portfolios. If there were a dramatic stock market pullback, we’d sell bond funds and buy more stock funds. Our weak outlook for stocks is one reason we’re not fully invested in stocks (although lower-risk portfolios will never be fully invested in stocks).

Second, bond funds do not offer a very compelling alternative to stocks right now. The stock market forecast you are referring to was made in our most recent stock market outlook in our favorite funds report for the second quarter 2006 – 5% over the next 12 months. Our bond outlook was no better. Since then, stocks and bonds have fallen, and we may increase our outlook for both in our next outlook.

CDs are no more compelling than bond funds – possibly even less so. If interest rates climb, as we think they may given we’re in shorter-term bond funds (which don’t fall as much when rates climb, but don’t go up as much when rates fall), we’d like to be free to benefit from the higher rates. Locking into longer-term CDs keeps one from taking advantage of the new higher rate environment.

But why buy a risky investment (stocks) that we expect to return 5% when a safe one (CDs or short-term bond funds) is expected (in fact guaranteed with CDs…) to return the same amount?

We find that when stocks are expensive investors should underweight them in general and focus on the few categories that are the least overpriced – not avoid them entirely. There is no perfect system for deciding when to get in and out of stocks. 

We may think stocks are slightly overpriced and have a target of 5% for the year on stocks, then see the entire stock market go up 15% to even more expensive levels. We may then lower our outlook to 0% for the next year, or even expect a negative return. If we were 100% in money market funds, CDs, or short-term bond funds, we’d be stuck earning 5% while the stock market took off. Then we’d have to enter at higher prices, or sit it out. If such a jump happened, we’d like to have something to sell, which we wouldn’t have if we were 100% in cash before the run-up. 

Worse, it’s possible the stock market could climb 10% over the next year while interest rates fall to 3% on reduced inflation expectations. If profits were strong for companies, and investors were not overly enthusiastic about stocks, we could maintain our outlook for stocks at 5% over the next year, even after the 10% run-up because stocks would be a better deal if you could only earn 3% in CDs or money market funds. 

Moreover, if we think the stock market in general is going to go up 5%, we also think certain categories of funds we favor could go up 6% - 10%, that is the whole idea of category ratings of 1 and 2 – categories that should outperform the broader market over the next 1 – 3 years.

The bottom line is, you want to decrease your allocation to stocks after big moves in short periods of time, and vice versa on declines.

You need to choose a portfolio risk level that doesn’t scare you in market pullbacks like we’ve seen in recent weeks (and they could get far more severe, like they did in 2002). You’d be better off in a lower-risk portfolio that you can stomach following rather than getting in over your head with risk, cashing out and going to CDs at exactly the wrong time – after a 20% - 30% pullback. For reference, our Aggressive Growth Portfolio is currently up just over 100% since the market bottomed out in 2002. However, this same portfolio fell near 17% in just four months leading up to the great comeback in stocks – a big hit in a short time for a diversified portfolio.

P.S. You’ll also note that many of the hardest hit areas in the recent pullback are fund categories we’ve sold down in our model portfolios in recent months or have downgraded in our category ratings (part of the our favorite funds report).