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CD Strategy - The Power of Two

Let me start off by saying that I have never purchased a CD. I like Ally's CD offerings because there's no minimum and the early withdrawal penalty is well-defined and easy to understand (namely, 2 months' interest). For reasons that I've discussed before (see
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, only 2 of their CDs really make any sense: the 11-month no penalty CD and the 5-year CD. But I don't think Ally's 11-month CD makes terribly much sense, either, given that its yield is less than that of their savings account.
When I think about CDs, 2 risks come to mind. There's the risk of interest rates going up while you're locked in to a low-rate CD. And there's the liquidity risk of paying a penalty to get at your principal. The strategy I propose here is to address those 2 risks.
Here's the idea. Suppose you have $15k you want to put in to CDs. Buy 4, 5-year CDs in the following amounts: $1k, $2k, $4k and $8k. That's it. You can make the strategy more or less complicated/flexible by buying more or fewer CDs. But before I get in to that, let me explain how this addresses interest rate risk and liquidity risk.
If interest rates go up, you have the option of paying the early withdrawal penalty and reinvesting the money. Today, the rate on Ally's 5-year CD is 1.58% and the early withdrawal penalty is 2 months' interest. So if you hold the CDs for 2 months, you'll break even. At 3 months, you'll get a 0.53% return; at 6 months, 1.05%. It's not great, but, given today's rates, I think it's pretty good.
Now what about liquidity risk? I'm sure you noticed that the dollar amounts I selected are $1k multiples of powers of 2. This enables you to withdraw any multiple of $1k while leaving everything else in tact. Need $7k? Cash out your $1k, $2k and $4k CDs but leave your $8k CD untouched. Yes, you'll have to pay the early withdrawal penalty on the CDs you cash out. But as I described in the previous paragraph, you can still get a reasonable return.
I mentioned that you can generalize this strategy with more or fewer CDs. If you have P dollars to invest and are willing to manage N CDs, the amount you put in the 1st CD is P / (2^N - 1). In the example above, P is $15k and N is 4, so it comes out to $15k / (2^4 - 1) = $1k. If you had $20k to invest and were willing to manage 5 CDs, you would put $20k / (2^5 - 1) = $645.16 in the 1st CD, $1290.32 in the 2nd CD, $2580.65 in the 3rd CD, $5161.29 in the 4th CD and $10322.58 in the 5th CD.
For those of you who listen to Cartalk, this is somewhat inspired by the $1000 in 10 envelopes puzzler. :-)
--Bill
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Bill Woessner

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