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
formatting link
, only 2 of their CDs reallymake any sense: the 11-month no penalty CD and the 5-year CD. But I don't thinkAlly's 11-month CD makes terribly much sense, either, given that its yield isless 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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