Low-Risk Investments - Keep Your Money Safe As It Grows
Putting your investments together should be like planning a meal. To make it well-balanced, you need a range of things that act differently yet work well together.
This means having a mix of high- and low-risk investments on the menu. After all, people have different tastes and more than one type of need.
When it comes to investing, there is a trade-off between risk and the rate of return you can earn. If you have the appetite for high returns, you have to accept a higher degree of risk.
Most people, though, want to keep at least some of their money safe. That's where low-risk investments come in. You might think of them as staples for your pantry.
This article explores the nature of low-risk investments, discussing some examples and alternatives - because at some point you'll be at the market, interested to explore your options.
What Is a Low-Risk Investment?
A low-risk investment is one whose primary goal is to protect your principal from loss. Return on investment takes a secondary role in determining its value to the investor.
The tricky thing about defining low-risk investments is that risk comes in different forms, but you can think of them in terms of whether they're long-term or immediate risks.
For example, you can keep money perfectly safe from loss - but if it doesn't earn a decent rate of return, it could fail to keep up with inflation or meet your future needs.
That's a risk that only takes shape over the long run. Of more immediate concern is the risk that you could lose money.
Losing money is the type of risk most people think of first. Typically, when they think of minimizing risk, they're thinking of safe investments that are not going to move up and down in value much and that are designed to limit the chance of permanent losses.
These safe investments are often designed to earn some form of income like interest payments, but not all income-producing investments are necessarily low-risk.
Risk is a matter of degree. Even among things that would be considered very low-risk investments, there can be differences in the level of risk. Here are some very low-risk investments (described further below):
- Traditional savings accounts
- Online high-yield savings accounts
- Money market accounts
- Certificates of deposit
- Cash-management accounts
- Treasury notes, bills and bonds
Traditional savings accounts
A savings account in an FDIC-insured bank is as safe as it gets.
These accounts do not fluctuate in value, they offer immediate access to your money and are protected by FDIC insurance.
The typical savings account provides a negligible return. According to the FDIC, the national average rate for savings accounts is .06%.
Traditional savings accounts are offered by banks and credit unions of all sizes. You might find them to be useful as an adjunct to your checking account, but it's not advisable to keep large sums of money in a savings account that pays as little as .01% to .03%.
At that level, a traditional or branch-based savings account barely provides any return whatsoever. Fortunately, there are better options to consider such as an online high-yield savings account.
Online high-yield savings accounts
An online high-yield savings account offers a number of distinct advantages over the traditional, branch-based savings account. Chief among them, a higher interest rate that does a little better job at keeping up with inflation.
High-yield savings accounts have the same features as a savings account - FDIC insurance, immediate access to your money, and your deposits do not fluctuate in value. However, because they are typically offered online, they're also available to consumers regardless of location.
Online high-yield savings accounts are pretty easy to open and many offer mobile banking apps that can help you manage deposits easily. But again, the America's Best Rates survey identifies the real advantage: online accounts generally pay several times more interest than traditional, branch-based accounts.
There are only two significant limitations to the low-risk characteristics of savings accounts:
- The insurance is limited to $250,000 per depositor.
- The interest rate is subject to change at any time.
That makes online high-yield savings accounts effective as a low-risk investment vehicle for your emergency fund, a place to store cash you'll use for large purchases, or to hold funds in between investments. Still, you'll want to make sure your online high-yield savings account is offered by one of the banks that consistently offers the highest interest rates.
Money market accounts
Money market accounts are handled a little differently than savings accounts by banks; but from the customer's point of view, they are essentially the same.
As long as the money market account is at an FDIC-insured institution, the same $250,000 worth of protection applies.
Money market accounts are also similar to savings accounts in that their interest rates are subject to change at any time. As with savings accounts, the best interest rates are generally found from online money market accounts. (And the America's Best Rates survey has shown over time that it's the same group of banks that consistently compete for your business on the basis of interest rate.)
Using money market accounts to your advantage
You might use an online money market account in the same way you would an online high-yield savings account. There are times when interest rates on money market accounts are even higher than for savings accounts. Staying abreast of interest rate trends can help you know which account to use to maximize your return at any given time.
Depending on your financial goals, having both types of accounts could be an especially effective strategy. For example, because Regulation D limits depositors to six withdrawals per month (not including ATM or teller withdrawals), having a savings account and a money market account for your emergency fund means you could make 12 withdrawals in a given month without incurring a fee.
Money market accounts are often used to house funds in between investments and also for your retirement funds in an IRA.
Certificates of deposit
Like savings and money market accounts, certificates of deposit (CDs) offer stable value plus $250,000 in FDIC insurance.
The twist is that a CD requires you to leave your money untouched for a specific time period. In exchange, the institution typically offers a set interest rate for the term of the CD.
Those characteristics represent a risk management trade-off. Having to commit your money for a particular length of time makes it less immediately available than if it were in a savings or money market account.
On the other hand, the fixed interest rate makes a CD's rate of return more predictable than that of a savings or money market account.
That fixed interest rate can be a drawback in times of rising interest rates, though, because you could find yourself stuck with a lower interest rate. Even with your low-risk investments, it's important to keep track of market forces so you know when to make a change based on how they're performing and whether they're actually meeting your financial goals.
Cash management accounts
If you have an investment account at a broker, you may be familiar with a cash management account (CMA). This is the portion of your account that is not currently invested in stocks, bonds or other securities.
Brokerage accounts typically sweep that unused money into a CMA so it can earn a little interest while being ready to invest anytime you choose.
CMAs are typically money market funds. These are similar to money market accounts in that they are designed to have stable values and earn interest. However, there is a key difference.
Money market funds are a form of mutual fund, not an FDIC-insured bank account. Thus they are not covered by FDIC insurance in the event that something should go wrong.
Treasury notes, bills and bonds
These are all securities backed by the U.S. government. In most cases, they pay a fixed rate of interest over the term of the security and their principal and interest is guaranteed by the U.S. government.
These securities are issued in lengths varying from one month to 30 years. The length of the security makes a big difference to their risk characteristics.
The government guarantees the face value of the bond when it becomes due. In the meantime, the market value of the bond can vary.
Bonds with longer terms are likely to vary the most in value. Thus, unless you plan to hold one of these securities until its due date, the value of your investment is not guaranteed. You could lose money if you sell at the wrong time.
So while short-term Treasury securities can be considered low-risk, long-term bonds do not really fall into that category.
Fixed-Rate vs. Variable Income Investments
Low-risk investments generally share the characteristic of being designed to produce income rather than growth. However, there is an important difference in how they produce income.
Some income investments produce a fixed rate of interest over their life spans. Most CDs and bonds pay the same interest rate from when they are issued to when they mature.
Exceptions to the above include indexed CDs and inflation-indexed bonds. For these, the interest you earn will vary according to specific market or economic events. However, these are not as common as bonds and CDs with fixed interest rates.
More common examples of variable income investments are savings accounts and money market accounts. Interest rates on these are subject to change at any time, so you can't predict how much income you'll earn on them in the future.
Other Income Investments
Because low-risk investments often produce income, people sometimes assume all income investments are low risk. This is not the case.
Two key characteristics determine whether an investment is truly low-risk:
- Is the principal value guaranteed?
- How safe is the issuer?
The following are some examples of income investments that don't really fall into the low-risk category:
Corporate bonds are a form of borrowing by corporations. The bonds are like a loan: The issuing company receives money for them, in return for which they must pay interest at regular intervals and pay the face value of the bond at the maturity date.
The risk factor is that corporations sometimes go bankrupt. When this happens, they may default on some or all of the principal and interest owed on their bonds.
Municipal bonds are issued by state and local governments. They often have tax benefits, but a guarantee from a state or local government is very different from the federal government guarantee that Treasury bonds carry.
Occasionally, a government may run into fiscal problems that prevent it from paying its debt obligations on time. In particular, municipal bonds that are funded by a single project as opposed to being a general obligation of the municipality carry the risk that the financial return on that project may not be sufficient to pay the interest and principal on the bond.
Dividend-paying common stock
Publicly traded shares of corporations are known as common stock. Many stocks pay regular dividends to their shareholders, which makes them income-producing investments.
However, stock dividend amounts are subject to change and can be eliminated altogether. Also stock prices are subject to fluctuation and have no guaranteed value. Thus, dividend-paying stocks are not low-risk investments.
Preferred stocks are dividend-paying stocks which give shareholders a higher claim on corporate earnings than those of ordinary shareholders.
This means that dividends on preferred stock are more secure than those on common stocks. However, those dividends still are not guaranteed, and the prices of preferred stock are still subject to change.
This is such a broad category that it spans many levels of risk.
Mutual funds are collections of securities in which fund shareholders own a common interest. The risk level and income characteristics depend on the holdings of the fund.
Generally speaking, risk can be controlled better by owning individual securities than by owning mutual funds. Even if a mutual fund holds low-risk securities like Treasury bills, the timing and cost of trades can result in losses.
Like mutual funds, annuities are a class of investment vehicle that can have a variety of different characteristics.
Annuities generally feature a guaranteed future income stream. The terms of the particular annuity determine the attractiveness of that income stream relative to the money that is paid for the annuity.
Most importantly, from a risk-management standpoint, annuities are guaranteed only by the insurance company that issues them. Thus the underlying risk of the annuity depends on the financial health of the issuing insurance company.
Planning Your Risk Strategy
Both risk level and income should be taken into account when choosing investments. The tax implications of income payments should also be taken into account.
A financial planner can help you balance these factors to plan your strategy toward risk and return.
If you prefer to develop your own strategy, be sure to consider how investments have performed in both bull and bear markets in the past. Also consider how current conditions, like exceptionally low interest rates, may cause future performance to differ from past returns.
Finally, even if you choose an investment for its low-risk characteristics, it is well worthwhile to consider the return as well. With a little searching you can find high-yield savings accounts, money market accounts and certificates of deposits that offer significantly higher interest rates without sacrificing the safety of your principal.