Investments are an essential part of any financial plan, but when it comes to safeguarding your money, low-risk investments can provide a sense of security.
Safe investments are typically recommended for those who are risk-averse. However, these low-risk investments can also be limiting.
It is vital to realize the relationship between risk and potential returns so that you can make your own investment decisions that will best suit your needs.
Understanding Investment Risk
You always take a risk when trying to gain something in life—buying your first home, changing jobs, or going back to school. But investing is not all that different from other things you do every day of your life without even realizing it.
And while the risks are important and may make some people hesitant about putting their money into stocks and bonds alike, there's also an opportunity for return. By considering investment risks and how they relate to potential returns on investments, investors can help strengthen portfolios by diversifying assets which will effectively increase one's chances at greater wealth over time.
Types of Risk
There are various risks associated with any investment. Some common types of risk include:
One type of risk is market risk, which is the risk that the value of your investment will fluctuate depending on macroeconomic factors. This can happen when you are looking at your account balance. There are many factors that make up market risk- recessions, politics, currencies, and more.
Interest Rate Risk
The risk of an investment changing in value because of changes to the interest rate environment is known as interest-rate risk. The types of risks are different for securities like bonds and stocks, with interest-rate risk affecting bond prices more significantly.
Another type of risk associated with investments is interest rate risk. Interest rates can increase or decrease over time, and if you are not able to keep up with these changes, your portfolio may be adversely affected. Either you earn less than expected on a fixed income account (like CDs) or lose money when the value of an adjustable-rate bond is less than the accrued interest.
A high yielding fixed deposit or corporate deposit at the highest available rate (currently over 9.50%), which pays out interest but offers no other investment avenue that matches the current market rates upon maturity (like with an interest pay-out after a year and prevailing interest rates around 8%).
Currently, at the high end of interest rate peaks, it is advised that you lock in your funds for longer periods in order to avoid reinvestment risk.
Political risk is the risk that an investment will not do well because of changes in government. Political risk can make it harder for an investor to make money because of political changes, like a new law or military control. The more time that progresses, the more likely political risk is to happen.
Legislative risk is an essential aspect to consider for all investments. Legislation can be introduced at any time and change the value of your investment, as well as other advantages it offers you, such as yield or payment type options.
The ability to trade a security in the future for its current value is known as liquidity. When an investment has little or no liquidity, this creates a premium to compensate the investor due to reduced trading opportunities.
Purchasing Power Risk
The inflation risk, or Purchasing Power Risk, is the chance that your assets might be worthless because of a rise in prices. Fixed-income investments are most affected by this, making them an imperfect investment for those who need to make sure they can afford something later on.
There are many different types of risks that can affect investments, but one which stands out is the tax risk. This means there's a chance an investment could be negatively affected by taxation from gains or losses. If you take into account taxes and don't accurately present them to investors, then this will lower profits for those at stake in your business--which wouldn't be good.
The Spectrum of Risk
There is a direct connection between the level of risk an investment carries and its potential rewards. This means that by understanding the risk-to-reward investment spectrum, one can categorize investments into three levels: high, medium, and low.
- Safe/Low Return: Treasury securities, CDs, savings bonds, life insurance
- Very Low Risk/Return: Insured municipal bonds, fixed and indexed annuities
- Low Risk/Return: Investment-grade corporate bonds (rated BBB or higher), uninsured municipal bonds
- Moderate Risk/Return: Income mutual funds, preferred stocks, utility stocks
- Medium Risk/Return: Equity mutual funds, residential real estate, blue-chip stocks, and investing in fine art can also offer a high return.
- High Risk/Return: Small-cap funds, small and mid-cap stocks, and mutual funds that invest in specific sectors of the economy, such as technology and energy
- Speculative/Aggressive Return: Limited partnerships, oil and gas investments, financial derivatives, commodities, penny stocks
When people invest or save money, they put it in risky places. They want to get a lot of money back. But sometimes they lose all their money, and it is gone forever. Understanding where different types of investments fall on the risk-to-reward spectrum can help people know what to do.
Yet, by understanding what type of risk an investment is exposed to, investors can make better decisions about what would be best for their own situation.
When to Go for the Low-Risk Choice
Low-risk investments are the ideal option for the following:
- You can't decide what to do with your money.
- You might need the money in less than ten years.
- Money for an emergency fund
If you are saving for a few years from now, you might want to put your money in something that offers a higher return. This might be something with more risk.
Building a portfolio means that you carefully pick investments that are different in risk, so they all work together.
The investments below come with insurance, so their risks are very small. But their yields are also very small compared with long-term returns from stocks. However, if you're willing to accept higher uncertainty levels, investing in stocks, bonds, or mutual funds with higher potential returns may be a better option.
Money Market Accounts
These are accounts that you can use to buy things. You can spend money from your account. There is a ceiling on how many times you can spend money per month.
These accounts are safe because the Federal Deposit Insurance Corporation backed these investments, which protects your money up to $250,000 per account and per investor.
The average interest rate is 0.10% (this rate may change). But many banks on the internet offer much higher rates.
Online High-yield Savings Accounts
These accounts are fundamentally similar to typical savings accounts, except that the banks may not have any physical locations. In turn, they pass these cost savings on to you as a higher interest rate.
These accounts, while not coming from a traditional brick-and-mortar bank, are still FDIC-insured.
All banking tasks are done online, from choosing a bank, enrolling in it, and transferring money to it.
Cash Management Accounts
We cannot be sure of the nature of these accounts today, but they work much like savings account. The providers of these products say that they are popular among online brokerages and Robo-advisors because it is easy for their customers to move money from accounts that invest to accounts where you save your money.
Cash management accounts are provided by non-bank financial institutions. But they are backed by the FDIC because they have partnerships with banks.
You can find these at online brokerages or Robo-advisors.
Certificates of Deposit (CDs)
Banks render CDs because it gives them a set amount of money upfront for a set period of time. They can use the money to lend to other customers or invest it. To get you to start a CD, they often offer higher rates than savings accounts. If you need the money for your CD, you will have to pay the penalty. The amount of the penalty is usually a few months of interest.
You can put your money into an insured account for a specified period, during which you'll receive a guaranteed interest rate.
CDs are offered by most banks, but they're often unfavorably high. Online banks typically offer higher yields for the same reasons noted above.
Treasury Notes, Bills, and Bonds
When you buy Treasury notes, bills, and bonds, you're essentially lending the government money. The government returns your investment back after the full period with regular interest payments and will pay you the bond's face value.
The difference between bills, notes, and bonds is primarily the length that the United States government holds your money.
- Bills are paid back in a year or less.
- Notes are paid back in 2 to 10 years.
- Bonds are paid back in 20 to 30 years.
When you buy a Treasury security from the government, it is backed by "the full faith and credit of the U.S. Government." It will pay interest regularly so long as you own that bond until its maturity date. Plus, they will give back to you whatever face value was promised at purchase if your holding onto that investment all along with no intention of selling before redemption day comes round again.
You can sell your bond if you want, but you will miss out on the interest payments that it would have made until it matures.
Fixed-rate Investments with Low Risk of Principal Loss
Contrast the options before; there are some risks to consider with each of these. But they are still included on the lower-risk side of the investment spectrum.
For these investments, you will need an online brokerage account. First, learn how to pick the best one for your needs. Then, once you have a brokerage account, use its investment screener to help you shop for any of the following investments.
Corporate bonds are one of the safest and most stable ways to invest your money over a given period of time. They work like small loans, but instead, you're loaning the company money instead of a bank.
The safest way to purchase and profit from corporate bonds is to find solid companies with a long-standing history of repaying their debt payments.
When you purchase a bond with a fixed interest rate from a creditworthy company and plan to hold it until it matures, bonds are considered safe investments.
Corporate bonds offer a guarantee from the company issuing them: pay you a fixed interest rate over a specified period of time and pay back the principal at the end. Generally, it is worth taking on more risk in order to receive higher returns.
If the company that provides the bond declares bankruptcy, it can default on its debt to you. This means your fixed-income disappears. But for strong and established companies, this risk is low.
Preferred stocks are an ownership share of a company that provides fixed payments.
Like bonds, preferred stocks have a fixed dividend, which is often paid out quarterly. The example below illustrates this feature. If the stock price is $100 and the yearly dividend is $5, then the yield--or return--is 5%.
The difference between preferred stocks and common stocks is that you receive the same dividend rate you were promised when you bought the stock, even if the company's value falls. This is different from common stocks, which have variable dividends rates and are not set.
The speed of a company's dividend growth is in the hands of each individual company, but most are trying very hard to avoid this because it means that they're in distress. If the business goes bankrupt, then bondholders get their money back before preferred stockholders.
Preferred stocks, as with bonds, typically don't have the same market value appreciation as common stocks. This is mainly due to interest rates affecting preferred stock values instead of company performance.
If you're unimpressed with the yields above and are willing to take on a little more risk for greater potential returns, explore these options: investments that come with some risk of principal loss but also offer much higher potential returns than other items listed above.
Dividend-paying Common Stocks
Dividend-paying stocks are shares of a company that pays you a part of the profit.
With a dividend-paying stock, when companies offer these stocks, they pay you a specified amount on a routine basis based on how many shares you own, just like preferred stock. Most of this is paid out in cash quarterly or monthly.
Investing in a dividend stock isn't the safe investment, it may seem. As with any other type of stock, when the price drops, you are still liable to lose money because of lost dividends as well. Moreover, your losses will be compounded if you have to sell at a lower price than what you paid for it.
Companies do not have to pay dividends to common stockholders. It is not guaranteed income like a government bond. If the company proclaims bankruptcy, dividends on common stock are last on the list, behind bondholders and preferred stockholders.
A mutual fund is a venture that enables investors to have exposure to several different assets.
Rather than investing heavily in individual stocks, you can invest in a mutual fund. These bundles come from many sources and often contain government or corporate bonds, commodities, or other kinds of investments. They let investors easily build diversified portfolios while keeping each small investment relative to the overall wealth.
Many investments can be found in different funds. Funds are made up of stocks with high and reliable dividends, bonds, and more. You can diversify your investments by choosing funds that are not the same type.
Mutual funds are just like stocks in that they can suffer short-term losses. Mutual fund investors, however, understand investments come with risk and volatility for the potential of greater returns.
Some mutual funds are actively managed. This costs more and can reduce the money you have in the future. To get better returns, find low expense ratio passive funds.
If you're going to invest, it's important that the risk is spread out. So instead of tossing all your money into one product or company, try spreading your investment across a number of them. If something goes wrong with just one thing, then there might be some other things for you to get back on track.
If you prefer a cautious yet steady investment strategy, government bonds and gilts can be helpful. While no investment is ever 100% safe, the safer investment is considered to be, the lower its return will likely be.