When it comes to investing, Certificates of Deposit (CDs) and stocks are two of the most common options. While both can help investors grow their money, they are considered entirely different assets that offer very different outcomes.
What are the differences between Certificates of Deposit and stocks?
Both Certificates of Deposit and stocks can be used as investments, but there are significant differences between them in terms of risk, returns, fees, and more.
Investment Returns
Traditional Certificates of Deposit typically offer nearly guaranteed returns if you keep your money in these accounts for the full term. For example, a one-year CD might provide an annual return of 1% if you keep your money there for a year, while a five-year CD might provide an annual return of 2% if you keep your money there for the entire five-year period. (You should remember that these are hypothetical examples.)
CD rates can vary significantly based on the overall interest rate environment, but the returns are predetermined, allowing you to plan accordingly. However, CDs generally provide lower returns in the long term compared to assets like stocks.
Note: In theory, there is no limit to the potential return of stocks, but you can also lose your entire investment. Unlike CDs, stocks do not have a fixed return rate, and returns can vary significantly between different stocks. Even for dividend-paying stocks, which can provide regular income, prices can fluctuate.
Risks
Certificates of Deposit are generally considered low-risk investments compared to stocks. This is because you usually cannot lose your initial investment with traditional CDs. If you withdraw your money early, you may face penalties, but often, these are the interest you earned. CD holders typically receive FDIC insurance to protect the original capital up to $250,000 if the bank fails.
In contrast, stocks are riskier because you can lose your money more easily. Some stocks are riskier than others; for example, small startups tend to have more volatile prices compared to large, well-known companies.
Fees
Banks typically offer Certificates of Deposit with no upfront fees, but if you withdraw your investment before the term ends, you may incur penalties. In many cases, these fees reduce the interest you would have earned rather than diminishing the original capital, but they are still a cost to consider.
On the other hand, investing in stocks can involve a variety of fees, including brokerage fees for each trade. However, stock trading fees have decreased in recent years, and some platforms offer commission-free trades.
Note: If you invest in stocks through assets like mutual funds or exchange-traded funds, you may pay an annual percentage of your investment as a management fee, along with other potential expenses.
Taxes
When you earn interest from Certificates of Deposit, that amount is treated as ordinary income, so it is taxed at ordinary income tax rates. Stock gains can have different tax implications.
When holding stocks for a short period, such as a year or less, gains are taxed as ordinary income. However, when held for a long term, that is more than one year, gains may be taxed at long-term capital gains tax rates, which are often 15% – significantly lower than ordinary income tax rates.
Losses on stocks can reduce taxable income.
Additionally,
Capital gains from stocks are not taxed until you sell them, so you can defer paying taxes on your gains. However, stocks that pay regular dividends are subject to ordinary income tax for the year in which the dividends are paid.
Liquidity
Certificates of deposit are not as liquid as stocks, because if you withdraw the principal early, you will not receive the full interest and may incur penalties. However, if you do withdraw early, it is a relatively straightforward process.
On the other hand, stocks often have strong liquidity if they are publicly traded. When the markets are open (during most weekdays), you can buy or sell stocks almost instantly.
Note: Some types of stocks have very low trading volumes, so it may take longer to find a buyer or seller. And if you want to withdraw cash, it may take a few days to complete the transaction and transfer the funds from your brokerage account to your bank account.
Volatility
Since certificates of deposit offer fixed returns, there is usually no volatility. If you have a five-year certificate of deposit with a specified interest rate, for example, you know that you will earn the same amount of interest every year.
On the other hand, stocks have volatility. They may rise a few points on some days and fall a few points on the following days. Stocks can rise or fall by double-digit percentages in a single day. So if you invest in stocks, you should expect some volatility.
Complexity
Certificates of deposit can be considered less complex than stocks in the sense that you can compare the interest rates of certificates of deposit between different providers to choose the one you want. In terms of stocks, past performance is not a guarantee of future results.
Just because one stock rose by 10% in one year does not mean it will happen the following year. Overall, analyzing stocks can be much more complex, with many factors to consider, such as the company’s financial performance, sector trends, and overall economic forecasts.
Special Considerations
There is a specific type of certificate of deposit called a market-linked certificate of deposit, which can be considered a hybrid between certificates of deposit and stocks. Market-linked certificates of deposit differ significantly from traditional certificates of deposit because they do not pay a fixed interest rate; instead, they are tied to an underlying market such as the S&P 500 stock index. In this case, a market-linked certificate of deposit can have variable returns depending on stock market performance, and different terms may apply, such as early withdrawal penalties.
Conclusion
Certificates of deposit and stocks can help investors grow their money, but they do so in very different ways. If you are looking for a low-risk asset with relatively low returns, certificates of deposit may be the optimal choice. For example, retirees might prefer the fixed income that certificates of deposit provide. If you are looking for a higher-yielding asset and are willing to take on more risk, stocks may be best.
You should remember that you can adjust your risk/return levels through various strategies, such as diversification, including investing in both certificates of deposit and stocks.
Frequently Asked Questions (FAQs)
What is the main difference between investing in certificates of deposit versus investing in stocks?
Certificates of deposit typically offer fixed interest rates for keeping your money for a certain period. The returns on certificates of deposit tend to be lower than those of the stock market over the long term. Stocks are more volatile and less predictable in their returns, but this risk generally leads to higher returns.
Do
Are stocks riskier than certificates of deposit?
Generally, stocks are considered riskier than certificates of deposit because you can lose money with stocks, whereas certificates of deposit have the protection of the original capital. However, certificates of deposit also come with some risks, for example, they are subject to inflation risk, as you can effectively lose money if their returns do not keep pace with inflation. However, there is no guarantee that stocks will generate returns, but they often perform well in inflationary environments.
What drives someone to choose certificates of deposit over stocks?
You might choose a certificate of deposit instead of a stock if you want a low-risk investment to protect your wealth. You may need to rely on a certain amount of interest, in which case a certificate of deposit may provide the stability you are looking for compared to a volatile stock. You may choose stocks over certificates if you want to try to achieve higher returns in the long run.
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Source: https://www.thebalancemoney.com/cds-vs-stocks-what-s-the-difference-5225412
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