Risk lies at the core of all investments. This notion reminds me of the first time I stood at the top of the high dive at the rec center pool. I was a nervous wreck. I never realized how afraid of heights I was until that moment. Many who never invested before have this same apprehensive feeling.
With the rising cost of living, it’s imperative that we invest, preferably with the lowest risk possible, to generate the highest yielding returns we can.
High rates of return on your investments are wonderful because you don’t have to invest as much capital to reach your investing goals. Yet the higher return you want, the more risk you take to get it.
As you near retirement, or your high school senior is about to enter college, your appetite for risk drops precipitously. You simply cannot afford to see a huge drop in the market right before the time you need to begin withdrawing funds from the investment accounts for retirement or college bills.
Instead, you need to shift to low-risk investments. These types of investments generate a lower return because you aren’t taking as much risk, but you’re OK with that. As the time to draw down the investments arrives, capital preservation is more important that astronomical growth rates. You need to know your account won’t drop 25% in a year and thwart your investing plans.
Best Low Risk Investments
Even those targeting low-risk, low-return investments face a wide array of options that can be confusing. Here are a few of your best low risk investment options for your portfolio.
1. Certificates of Deposit
There is nothing more boring than a certificate of deposit. You can get it through your bank, your credit union or even your investment broker.
With a certificate of deposit (CD) you trade depositing your money for a specific length of time to a financial institution.
In return, you get a set interest rate for that period and it does not change, no matter what happens to interest rates. You are locked in until maturity of the term length. You can withdraw from the CD early for a penalty that is usually equal to three months’ worth of interest.
Why are CDs at the top of our best low risk investment list? Because as long as you get a certificate of deposit with an FDIC-insured financial institution, you are guaranteed to get your principal back as long as your total deposits with that lender are less than $250,000. The government guarantees that you cannot have a loss, and the financial institution gives you interest on top of that.
How much interest you earn is dependent on the length of the CD term and interest rates in the economy. Interest rates are low, but if you lock in your money for many years you can get a little bit more interest.
You can open a CD with great interest rates with CIT Bank, Ally Bank and Capital One 360 (formerly ING Direct). CIT, for instance, pays 1.15% annually for a two-year CD.
2. Treasury Inflation Protected Securities (TIPS)
The U.S. Treasury has several types of bond investments for you to choose from. One of the lowest risk is called a Treasury Inflation Protection Securityor TIPS. These bonds come with two methods of growth.
The first is a fixed interest rate that doesn’t change for the length of the bond. The second is built-in inflation protection that is guaranteed by the government. Whatever rate inflation grows during the time you hold the TIPS, your investment’s value rises with that rate.
For example, say you invest in a TIPS today that only comes with a 0.35% interest rate. That’s less than certificate of deposit rates and even basic online savings accounts. This isn’t very enticing until you realize that, if inflation grows a 2% per year for the length of the bond, then your investment value increases with that inflation, and gives you a much higher return on your investment.
TIPS can be purchased individually or you can invest in a mutual fund that owns in a basket of TIPS. The latter option makes managing your investments easier, while the former gives you the ability to pick and choose with specific TIPS you want.
A money market fund is a mutual fund with the main purpose of not losing any value of your investment. The fund also tries to pay out a little bit of interest as well to make parking your cash with the fund worthwhile. The fund’s goal is to maintain a net asset value (NAV) of $1 per share.
These funds aren’t foolproof, but do come with a strong pedigree in protecting the underlying value of your cash. It is possible for the NAV to drop below $1, but it is rare. The interest income is tiny, but your money is relatively secure.
4. Municipal Bonds
When a state or local government needs to borrow money, it doesn’t use a credit card. Instead, the government entity issues a municipal bond. These bonds, also known as munis, are except from federal income tax at the very least. Most states and local municipalities also exempt income tax on munis for issuers in the state, but talk to your accountant before making any decisions.
What makes municipal bonds so safe? Not only do you avoid income tax (which means a higher return compared to an equally risky investment that is taxed) but the likelihood of the borrower defaulting is very low. There have been some enormous municipality bankruptcies in recent years, but these are very rare. Governments can always raise taxes or issue new debt to pay off old debt, which makes holding a municipal bond a pretty safe bet.
5. U.S. Savings Bonds
These are similar to TIPS because they are also backed by the federal government. The likelihood of default on this debt is microscopic, which makes them a very stable investment. There are two main types of US Savings Bonds: Series I and Series EE.
Series I bonds consist of two components: a fixed interest rate return and an adjustable inflation-linked return, making them somewhat similar to TIPS. The fixed rate never changes, but the inflation return rate is adjusted every six months and can also be negative (which of course brings your total return down).
Series EE bonds just have a fixed rate of interest that is added to the bond automatically at the end of each months, so you don’t have to worry about reinvesting for compounding purposes. Rates are very low right now, but there is an interesting facet to EE bonds: the Treasury guarantees the bond will double in value if held to maturity, which is 20 years.
If you don’t hold to maturity you only get the stated interest rate of the bond minus any early withdrawal fees. Another bonus to look into: If you use EE bonds to pay for education, you might be able to exclude some or all of the interest earned from your taxes.
Looking to purchase some Series I or Series EE Bonds? You can do that directly through TreasuryDirect.gov.
6. Annuities
Annuities have a bad reputation with some investors because shady financial advisors over-promoted them to individuals where the annuity wasn’t the right product for their financial goals. Annuities don’t have to be scary things; they can help stabilize your portfolio over a long period.
But talk with a good financial advisor first: Annuities are very complex financial instruments with lots of catches built into the contract.
There are several types of annuities. But in all cases, when you purchase an annuity you make a trade with an insurance company. They take a lump sum of cash from you. In return they give you a stated rate of guaranteed return. Sometimes that return is fixed (with a fixed annuity), sometimes that return is variable (with a variable annuity) and sometimes your return is dictated in part by how the stock market does with guaranteed basic level that gives you downside protection (with an equity indexed annuity).
If you get a guaranteed return, your risk is a lot lower. Unlike the backing of the federal government, the insurance company backs your annuity (and perhaps another company that further insurers the annuity company). Nonetheless, your money is typically going to be very safe in these complicated products.
7. Cash Value Life Insurance
Another controversial investment is cash value life insurance. First, this insurance pays out a death benefit to your beneficiaries when you die; a term life insurance policy gives you this. Other types, known as cash value policies, do that and also build up an investment account from your payments. Whole life insurance and universal life insurance are the chief cash value offerings.
While term life insurance is by far a cheaper option, it only covers your death. One of the best perks of cash value life is you can borrow against the accrued investment value throughout your life, but isn’t hit with income tax. It is a clever way to pass some value onto your heirs without either side getting hit with income tax.
Middle Risk Investments
If you don’t want to go all in on the riskiest class of assets, you can still generate higher returns by taking a few steps in that direction. Here are a few investments that add a bit more risk to your portfolio.
8. Dividend Paying Stocks and Mutual Funds
One of the easiest ways to squeeze a bit more return out of your stock investments is simply to target stocks or mutual funds that have nice dividend payouts. If two stocks perform exactly the same over a given time, one with no dividend and the other paying out 3% per year, then the latter stock is a better choice.
Of course, picking individual stocks isn’t easy. Use some of the trading tools at Scottrade or E*Trade to help you target dividend stocks. Stock-picking comes with risk that the company may falter and take your investment down with it. A safer bet is to invest money into a dividend stock mutual fund. With this fund type, the fund company targets stocks that pay nice dividends and does all of the work for you. You also get diversification so that one or two stocks can’t tank your entire investment.
9. Preferred Stock
This is a type of stock has both an equity (stock) portion and a debt portion (bond). In the credit hierarchy, governing which investors get paid first during a bankruptcy, preferred stock sits between bond payments, which come first, and common stock dividends, which come last.
Preferred stock is not traded nearly as heavily as common stock, but do have less risk than the common stock. It is just another way to own shares in a company while getting dividend payments.
You can track down preferred stock investments at Scottrade, E*Trade and Capital One ShareBuilder.
P2P lending is a completely different type of investment. Instead of buying shares in a company and its future profits, you lending your money to someone else in hopes they will pay you back. This makes peer to peer lending risky if you screen poorly. If you fund a terrible loan, you might not get your money back.
On the other hand, having a solid borrower means you can earn some really nice returns. Thankfully, P2P lending companies have worked to offer screening tools and portfolio settings for your investment gain. Instead of going through every single loan, which you can still do, they allow you to target a certain rate of return, and the company takes care of lending out money to a group of borrowers.
Note that these companies, which lend money to strangers on the Internet, have a first-rate collection process. Lending Club in particular has done a great job in setting up its collection operation, thus protecting their investors.
