While some investors are inclined to take more risk than others, there is always a place for low risk investments as part of a properly-balanced portfolio. This need is particularly evident when the stock market turns volatile.
In this article, we're going to talk about the relationship between risk and reward. As part of that discussion, we're going to focus on low risk / no risk investments, and their role in a balanced portfolio. Next, we'll provide a brief description for some of the more common investments of this type. Finally, we'll finish with some tips that should help identify low and no risk investments that are much riskier than they appear to be on the surface.
Risk, Reward, and Investments
In the long term, there is a strong relationship between risk and reward. The classic investment examples include stocks, bonds, and treasury bills. As the risk of each investment diminishes, so does the reward:
- Stocks: Investors buying stock in a company are taking an ownership position in that business. As such, they will share in the rewards of the company when profits are high.
- Bonds: When an investor purchases the bonds of a company, they're helping to finance that company's operations. In this capacity, they are acting as creditors of the business. In exchange for a lower return on their investment (relative to shareholders), creditors are paid before any money is returned to shareholders.
- Treasury Bills: In the same way that bonds are investments in a company, treasury bills, or T-bills, are investments in the U.S. government. Lending money to the U.S. government is considered a very safe investment because the risk of default, or non-payment, is very low. For this reason, the return on government securities will be less than bonds or stocks.
Balancing a Portfolio
Every investor has a slightly different risk profile. Balancing a portfolio is all about understanding, accepting, and controlling that risk. Understanding risk is gained by asking questions about the investment itself. Accepting risk is a fact all investors need to appreciate: greater risks are normally accompanied by greater rewards. Controlling risk is achieved by balancing a portfolio and monitoring that balance.
A diverse set of investments will consist of a mix of stocks, bonds, and low risk or "no risk" investments. The exact mix of these assets will determine the overall risk of the portfolio, which is hopefully aligned with the investor's risk profile and / or investment objectives.
Items to consider, or questions to ask, when trying to determine the risk associated with a particular investment include:
- What are the objectives of the investment? For example, safety, growth, income.
- What are the costs associated with the investment? These might include fund loads, management expenses, and bank fees.
- What is the historical performance of the investment? Past performance does not guarantee future results.
Attributes of a Low Risk or No Risk Investment
Investors generally seek out low risk investments when they need to preserve capital (their original investment). For example, the investor might pay their monthly bills or mortgage payment using these assets. Likewise, the investor may need a large amount of cash to pay for a future expense that will occur in the near term.
For the reasons explained above, a low risk investment's objective should be safety or preservation of capital. The fees should be very low (less than 1%), or there should be no fees. The historical performance should be steady, relatively modest growth.
Low Risk / No Risk Investments
The relationship between risk and reward dictates that a low risk investment will also be associated with a low return. This should be the expectation of the investor. The most common types of low risk / no risk investments include:
- Savings Accounts: Banks or credit unions pay a fixed interest rate when a customer deposits money into an account. The interest rates on these deposits are normally relatively low. These are safe investments, which are generally insured by the FDIC against loss.
- Money Market Accounts: These types of accounts are similar to savings accounts except they usually pay a higher rate of interest. Banks and other financial institutions are willing to pay higher rates because the funds deposited in a money market account are subject to restrictions such as minimum deposits and frequency of withdrawals.
- Certificates of Deposit: Another low risk investment, certificates of deposit, or CDs, offer higher interest rates than money market accounts. With a certificate of deposit, the money is deposited for a fixed period ranging from one month to several years. Money withdrawn before the maturity date is generally charged a fee or penalty. CDs are the highest interest-bearing account that is FDIC insured for deposits up to $250,000 in the event the bank fails.
- Bonds: Investors that purchase and hold bonds are creditors of that company. That is to say, a bond is a loan of money to a business. As such, the agreement is to repay the face value of the security on a future date in time (the maturity date). Savings bonds and treasury bills are backed by the U.S. government, and are considered free from any risk of default.
Oftentimes, unscrupulous marketers will promote investments as "low risk" or "no risk." In reality, these schemes carry significant risk. Anytime the balance of risk and reward seems out of kilter, the offer is likely to be too good to be true.
Below is a listing of the most common forms of these investments offered by dishonest promoters:
- Pump and Dump: Also referred to as "hype and dump," these schemes involve the heavy promotion of a company's stock (typically a micro-cap or penny stock), including misleading information concerning future profits. The increase in demand for the stock results in a sudden rise in the stock's price per share. At this point, the promoter begins to sell their over-priced stock.
- Pyramid Schemes: Participants will attempt to make money by recruiting new members into the pyramid. As these new members join the pyramid, they pass their money on to their recruiters. The scheme is in play as long as new members can be enrolled. Once this stops, the pyramid collapses..
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