Major Types and Why They’re Low-Risk
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- Risk is inherent to investing, and there’s no ironclad rule about the best way to approach it.
- Risk tolerance is based on your emotional response to financial risk, while risk capacity is more objective.
- Balancing risk tolerance with risk capacity is key to developing the right investment plan for you.
When it comes to investing, nothing is 100% safe. Investing means you’re putting money into something — a financial asset of some sort — in the hopes of getting a return. Where there’s the chance of a gain, there’s always going to be the chance of a loss, too. Risk and reward are two sides of the same investing coin.
That said, not all investments are created equal, risk-wise. Here are seven investments that can be considered safe: That is, they will almost always return to you what you put in. Plus some return as well.
1. Certificates of deposit (CDs)
What they are: CDs are offered by banks or credit unions. They’re technically a type of temporary deposit account. They offer a fixed rate of interest in exchange for keeping your funds in the account for a certain amount of time — generally, six months to five years. Usually, the longer the term, the higher the annual percentage yield (APY).
Why they’re safe: Federally insured banks rarely go out of business. Even if they did, as bank products, CDs are covered by FDIC insurance, up to $250,000 per account-holder.
2. US Treasuries
What they are: Issued by the Dept. of the Treasury, US Treasury bonds are like a loan you make to the US government: You buy the bond (or the note or the bill, as the shorter-term loans are called) and the government promises to pay you back later, with interest.
Why they’re safe: Treasuries are backed by the “full faith and credit” of the US government. In its 245-year history, that government has never defaulted on a debt, making US Treasury bonds the closest thing to a risk-free investment out there. In fact, they often act as a safety comparison for other investments.
3. Money market funds
What they are: Money market funds are a type of mutual fund that invests in short-term debt instruments and pays out earnings in dividends. A typical annual return is between 1% and 2%.
Why they’re safe: The short-term debt assets that money market funds hold tend to be very low-risk themselves, like CDs and US Treasuries. They are very liquid and come from sound issuers.
4. AAA-rated corporate bonds
What they are: Corporate bonds are debt instruments used by companies to raise money. Investors buy the bond, essentially loaning money to the issuing company, and then receive regular interest payments. When the bond matures, the company pays back the principal. Corporate bonds receive letter grades from independent credit rating agencies; these ratings reflect the financial soundness and credit history of the issuing company.
Why they’re safe: The AAA rating is the highest grade a company and its debt can receive. Companies rated AAA by credit rating agencies have been judged to have an extremely high capacity to meet their financial obligations — so it’s unlikely they’ll default on the bond’s interest payments or fail to repay the principal. AAA-rated corporate bonds are considered only slightly riskier than US Treasuries.
5. Blue-chip stocks
What they are: Blue chips are stocks from large, well-established, and well-endowed corporate giants like Apple, Bank of America, Coca-Cola, Johnson & Johnson, Starbucks, and Visa. They are considered the lowest-risk of equities.
Why they’re safe: As stocks, blue chips rank higher on the risk spectrum than bonds, but not by much. These companies have “made it” — they have long histories of success and are often leaders in their fields. They pay dividends steadily, and their shares hold their value; both tend to move gently but steadily up. No guarantees, of course — there have been blue chips that crashed and burned in the past — but it’s more likely that at worst, a blue chip will stagnate, rather than decline, in value.
6. ETFs with bond or blue-chip portfolios
What they are: Exchange-traded funds are publicly traded securities that hold a basket of similar assets, often designed to track an index of a particular type of asset. There’s an ETF for just about every asset in the investment universe, and that includes low-risk ones. like Treasuries, AAA corporate bonds, and blue-chip stocks.
Why they’re safe: Diversification by its nature lessens risk: It’s the old safety-in-numbers principle. ETFs that purchase a portfolio of other low-risk assets, like bonds, are particularly low risk. Economical, too: Buying just a few shares of an ETF gives you exposure to dozens of bonds or stocks.
7. Fixed-rate annuities
What they are: Annuities are an insurance product, technically a contract with an insurer. You invest a sum with an insurance company now, and they pay your principal back to you with interest in a series of payments later — for a set period, or even as long as you live. There are different types of annuities, but fixed-rate annuities — which pay the same, set amount of interest — are among the lowest-risk.
Why they’re safe: Dierdre Woodruff, senior vice president and secretary at Canvas Annuity, notes that you’re guaranteed to get your money back, with a predictable interest rate. It’s part of your arrangement with the insurance company. They are obligated to make those payments at the set rate. “As long as the policyholder leaves their money in the contract for the entire term, they can calculate exactly what their return will be at the end of the term,” says Woodruff.
Of course, there’s always the risk the insurance company will fail (and no, there’s no FDIC insurance that covers your funds).
Risk tolerance vs. risk capacity: at a glance
As an investor, your personal perspectives and responses to potential loss are what determine your risk tolerance. Risk capacity, on the other hand, can be essentially boiled down to numbers: how much you need your investments to generate, how much you have, and how much you’ll add to them in the future.
Risk tolerance: This is often defined as the emotional, subjective viewpoints on financial risk for an investor.
Risk tolerance is one of the first things an investor needs to consider before mapping out a plan. One might look at it as a person’s ability and willingness to lose some or all of an investment in exchange for greater potential returns.
Risk tolerance isn’t easily quantifiable, of course, because emotions rarely are. Warren Ward, a CFP® professional with WWA Planning & Investments, says he defines risk tolerance for his clients as how “emotionally comfortable” they are with risk.
One way to determine your risk tolerance is by asking yourself hypothetical questions, such as: “How would you react if the value of your investments dropped by 20%?” Financial advisors and planners often use this approach to gauge clients’ risk tolerance.
Investing requires taking risks. There’s no way around it. When creating an investment strategy, there are two aspects of risk to consider: risk tolerance and risk capacity.
Risk tolerance is generally associated with the emotional side of investing, while risk capacity is a more objective measure based on financial facts. Two investors with the same risk capacity might have significantly different risk tolerance levels due to personality, money history, and other factors.
Risk tolerance vs. risk capacity: at a glance
As an investor, your personal perspectives and responses to potential loss are what determine your risk tolerance. Risk capacity, on the other hand, can be essentially boiled down to numbers: how much you need your investments to generate, how much you have, and how much you’ll add to them in the future.
Risk tolerance is one of the first things an investor needs to consider before mapping out a plan. One might look at it as a person’s ability and willingness to lose some or all of an investment in exchange for greater potential returns.
Risk tolerance isn’t easily quantifiable, of course, because emotions rarely are. Warren Ward, a CFP® professional with WWA Planning & Investments, says he defines risk tolerance for his clients as how “emotionally comfortable” they are with risk.
One way to determine your risk tolerance is by asking yourself hypothetical questions, such as: “How would you react if the value of your investments dropped by 20%?” Financial advisors and planners often use this approach to gauge clients’ risk tolerance.
The three most common levels of risk tolerance are:
- Conservative: A conservative investor prefers to avoid unnecessary risk and focus more on avoiding loss than on pursuing gains from investments.
- Moderate: A moderate investor is willing to take some risks, but has backstops in place to prevent losing too much.
- Aggressive: An aggressive investor is comfortable with higher potential risks in exchange for potentially higher returns.
You can calculate your risk capacity based on your income, assets, and expenses.
Risk capacity is how much risk you can afford to take as an investor and depends on such aspects as your earning power, time horizon, and current assets. Johnson explains that it is “easily determined and quantifiable.”
Ward says risk capacity is “just basic math” that shows your ability to withstand a financial setback. Look at these primary factors to determine your risk capacity:
- Income you’ll require during retirement
- Number of years until retirement
- Current income and savings rate
- Current assets accumulated
Robert R. Johnson, a chartered financial analyst (CFA) and professor of finance at Creighton University, points out that certain circumstances typically increase your risk capacity. A longer time horizon, substantial assets, and significant earning power all offer greater ability to bear risk. Conversely, factors like a short time horizon, less money in savings, and lower income potential reduce your risk capacity.
What is a low-risk investment?
Investment risk comes in several varieties, ranging from something intrinsic to the individual investment — like a company’s earnings, which often affects its stock price — to big-picture items, like the overall performance of the stock market or the outlook for the economy.
Still, risk can be characterized in a couple of general ways, says Tricia Rosen, principal at Access Financial Planning: volatility and liquidity.
“Volatility is how much the value of a security moves up or down — both in quantity and speed,” Rosen says. “Liquidity is access to your asset. An asset is less liquid if it takes longer to convert the asset to cash or if there’s a decrease in the value associated with converting the asset.”
There’s no single definition or magic number to define “low-risk,” but low-risk investments do share some traits. They tend to be non-volatile — no big price swings — and they tend to be liquid — that is, easily sold and turned into cash.
Drawbacks of safe investments
Playing it safe can have drawbacks, too. Here are some downsides to low-risk investments.
Low returns
Low-risk investments protect you on the downside, but often don’t offer much on the upside. And the safer they are, the less they pay. Citing the “Stocks, Bonds, Bills and Inflation (SBBI) Yearbook”, Robert R. Johnson, professor of finance at Creighton University’s Heider College of Business, notes that Treasury bills only returned 3.3% annually between 1926 and 2019. In contrast, large-cap stocks returned 10.2%.
And you do lose something with safe investments: the opportunity for higher returns — from another investment.
Inflation risk
Another downside to low-risk investments, especially those paying fixed interest rates, is inflation risk — the risk that rising prices will eat into the principal or the returns of your investment. That’s one reason why longer-term CDs and bonds pay higher interest than shorter ones — the increased risk from inflation.
That’s why time matters. If an investor’s time horizon is short, low-risk investments with low yields can work. But over a long term, low-risk investments that pay returns lower than inflation end up losing their value.
Illiquidity
Although liquidity is a component of low-risk investments, many of them do lock up your money. CDs often charge fees if you want to cash out before the term ends, called an early withdrawal penalty. Annuities can come with steep penalties for taking your money out early, especially after payments begin. Rosen suggests that this illiquidity puts them slightly higher on the risk spectrum.
The bottom line on low-risk investments
Any investment has some risk. But if you invest in the low-risk assets above, you’ll almost always get back what you put in — and usually more.
Although every portfolio can use some of the safety they offer, they’re best for very conservative investors who want to access their money in the short term.
Just be aware that low risk also typically means low yield. In the long term, if they don’t keep up with inflation, these can actually cost you money.
Investors with longer investment horizons are probably better off accepting some risk of loss in order to hedge against the risk of inflation.
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