I got a question the other day as to whether a high rate CD could be used to function as the ‘risk-free’ asset in an investment portfolio to improve investment results. I said, “why not?” In all honesty there is clearly risk in CDs or money market accounts or savings accounts – primarily the interest income portion of those assets are at risk (principal is FDIC insured at those type insitutitions if your accounts are setup correctly).

Given the question came from my friends at kidssavingsaccount.info I offered to write a guest post on the topic and explain how a high interest savings account or high rate CD could function to improve the risk/return profile of a risky asset portfolio.

What I discuss is what the risk/return profile looks like when you take a risky asset portfolio and allocate some portion of the investment in a ‘risk-free’ asset such as a CD and the remainder in your efficient portfolio of risky assets. KidsSavingsAccount.info probably isn’t the right venue for such a high level discussion true, but we aren’t really getting into the mechanics of how these portfolios are created – we only discuss what the expected performance of said portfolios looks like, and how a fixed income asset can enhance that picture. Clear as mud, right?

Think of it another way. You don’t have to know how an engine works to use a car to get from point a to point b – but you do have to be able to recognize that a car needs an engine to move. Likewise an efficient portfolio needs to be paired with a risk-free asset or fixed income asset to acheive an optimal profile picture.