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Money for nothing?
Hybrid investments offer stock-market exposure and limited downside -- are they worth it?
December 3, 2003: 9:33 AM EST
By Walter Updegrave, CNN/Money contributing columnist

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NEW YORK (CNN/Money) - What do you think of "Market Linked CDs"? They seem to offer safety of principal while also providing a shot at stock market returns. Are they a good deal?

-- Len, Milan, Mich.

The CDs you're referring to go by a variety of names: Market Linked CDs, Equity Indexed CDs, Equity Linked CDs as well as some other variations.

There's also a fixed annuity version of these products that usually goes by the name Index Annuities.

While specific terms will vary depending on the institution selling it, equity-linked CDs and annuities generally work like this: You invest in the CD or annuity for a specific term, usually five to 10 years (although it could be as short as one year). Instead of earning a stated rate of interest, you get a return based on the appreciation of a stock index, usually the Standard & Poor's 500.

You're typically guaranteed that no matter what happens to the stock market, you will at least get back your original investment. And in some cases, you may also receive a guarantee of a minimum return -- say, 2 or 3 percent per year.

All that glitters...

So what's not to like? After all, you have upside of the stock market and a limited downside. So you're getting the best of both worlds, safety and return. All gain, no pain, right?

Well, I guess that depends on how you define gain.

Although indexed CDs and annuities do allow you to participate in the gains if the stock market rises, there's usually a limit to how much of that gain you get to share.

For example, equity linked CDs and annuities usually calculate their return based only on the price gains of the S&P 500, which means you don't share in any dividends. While dividend payments aren't exactly humongous these days, they can still add up over the course of several years.

Some indexed products may limit the gain in other ways.

You may get a "participation rate" of, say, 70 percent, meaning your return would be equal to 70 percent of the S&P 500's price gain.

Or, the CD or annuity issuer place a ceiling on your return, in which case you wouldn't share in any gains beyond the cap.

Some may even be callable, which means if the S&P 500 is going like gangbusters, the issuer has the right to call your CD or annuity -- that is, cash you out early for a predetermined return.

In other words, just when the ride is getting interesting, you might be dumped out of the vehicle.

So is it worth it?

Given these limitations -- and the fact that you've practically got to be a financial genius to sift through and understand all the conditions -- I'm not a big fan.

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That's not to say that they couldn't be right for investors who are so risk averse that they otherwise wouldn't invest in stocks at all.

But I think the vast majority of investors are much better off balancing return vs. risk by setting an appropriate asset allocation policy -- a fancy name for deciding how much of your money needs to be invested for long-term growth and how much needs to be in less volatile investments like bonds and CDs. [To learn more about asset allocation,click here, and for advice on how to divvy up your assets, click here.

By forgoing the hybrid approach in favor of investing in some securities designed to provide growth and others designed for income and stability, you'll get the full benefit of the stock market's growth in the portion of your stash invested in stocks or stock mutual funds, while getting the benefit of security in the portion invested in CD.

And equally important from a mental health standpoint, you'll avoid the risk of your brain seizing up in the face of the mind-numbing permutations of the various CD and annuity index products being sold today.

Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 PM on Mondays.  Top of page

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