Safe savings and inflation
Question: We currently have 12 months of income in savings - laddered CDs through our credit union earning up to 1.982% interest. We can withdraw from them one time without penalty. What's a better way to invest 6 months worth of the savings to keep ahead of inflation? We're not big risk takers, but don't want to lose value to inflation. In what circumstance/ what time horizon would make an indexed mutual fund a good choice? Anne, St. Paul, MN
Answer: You're in a good financial situation with 12 months of income in savings. For most people that's a goal, not a reality. Congratulations.
Basically, your strategy of laddered short-term CDs does provide a reasonable hedge against inflation, with a lag. The reason is that interest rates will go up when inflation does stir (it's dormant right now). The combination of Federal Reserve tightening and investor fear about rising prices will push up interest rates. Since your CDs mature fairly quickly you'll be able to reinvest the money at the higher interest rates and, therefore, keeping pace with inflation.
Treasury bills are also a good hedge against inflation. Mark Kritzman, head of Windham Capital Management and a financial engineering instructor at MIT, looked into constructing inflation-resistant portfolios using data from 1974 to 2009. A striking result of his research is how "Treasury bills track inflation better than any other asset, but they offer little upside." (By the way, the same can't be said for long-term government debt or long-term CDs--inflation hammers their value.)
You said that you aren't big risk-takers. The advantage of laddered CDs, Treasury bills, online savings accounts, and the like is that the money will be there when you need it. Your money will hold its value over time, adjusted for inflation. The problem is these kind of safe investments, while terrific for emergency funds is that they don't offer any prospect of earning a positive return above the rate of inflation. Right now, the return on blue chip safe investments is about zero.
That's where your question about indexed equity mutual funds comes in. ((I'm assuming when you ask under what circumstances it makes sense to buy an indexed mutual fund you mean an equity index fund.) Good stocks with plenty of cash flow typically get hammered when inflation rears, but only short-term. The track record is that blue chip corporate earnings keep pace with inflation since these companies have some ability to raise their power. Problem is, you probably shouldn't own an equity index fund in a taxable account unless your time horizon for owning it is longer than 5 years. Stocks are volatile--it's in the nature of the investment.
I like the idea of adding a sliver of equity investments to your taxable portfolio since you have a healthy sum of money set aside in safe investments. But you would have to be able to leave the equity investments alone for a long time--and be comfortable with some wild wings in value--along the way