What is a Low Risk Investment?
The answer to this question depends on your time horizon
. If you need access to your capital in the next few years (ie. less than 5 years), then you clearly cannot afford to take on a lot of volatility. No one really knows what the stock market returns will be in the short run. For the short term investor, some common fixed income, low risk investments include:
- Certificates of Deposits (CDs)
- FDIC insured Money Market Accounts
- FDIC insured Online Savings Accounts
- Bonds and Bond Funds
These financial instruments will barely keep pace with inflation, but you can rest assured that your capital will not be wiped out if the market tanks. Please keep in mind that bond funds are not risk free. They can and do lose their value. Even money market funds are not totally risk free. An additional risk associated with bonds, especially long term bonds, is interest rate risk. As interest rates go up, the value of long term bonds fall. This makes sense, right? Why would investors tie up your money in a 30-year bond yielding a fixed 4% rate when the interest rates are climbing? As the demand for these bonds falls, so does their value.
Your investment time horizon is a huge consideration when designing an asset allocation strategy. Although the volatility of common stocks is your enemy in the short run, this very same volatility is your friend in the long run. In his book Asset Allocation, Roger Gibson argues that an investor with a long time horizon is actually following a low-risk strategy by holding common stocks because it offers protection from the biggest risk he faces in the long run – inflation.
Historically, over long periods of time, common stocks have outperformed other less volatile investments. The longer your investment horizon, the more your risk that inflation will eat away at your principal. The way to fight the inflation beast is by taking on some volatility in the form of common stock exposure. While there are no rules etched in stone about the percentage of your assets to invest in stocks, I like John Bogle’s (founder of The Vanguard Group) ultra simple 100-minus age rule. You subtract your age from 100 and that is the percentage of your assets that should be in stocks. The rest should be in low volatility fixed income instruments. Bogle is a huge proponent of index investing. He argues that most people are better off owning an index which represents the whole market rather than to trying to pick individual winners.
Part 1 – Investment Risk
Part 3 – Is Index Investing The Answer?
Part 4 – A Free Tool for Identifying Low Risk, High Return Investments