Risk and return are related.
That’s a truism about investing. Investors who eagerly jumped into Amazon.com stock back in the late 1990s were taking a risk on the strange new business of online bookselling. Nobody really knew if this oddity would work out.
Of course, Amazon’s return since then has been astronomical.
On the other hand, when you park cash in a standard bank account or money market fund, you’re not worried about the safety of your funds, but you don’t have any expectation of getting an eye-popping return.
Swinging for the fences to nab the highest possible return isn’t the right thing for every investor.
However, balancing higher-risk investments with lower-risk instruments is something financial advisors frequently counsel their clients to do.
So should you include low-risk investments as portfolio allocations?
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What is risk?
Investment risk sounds like something you might want to avoid, but what is it exactly?
In a nutshell, risk is the possibility that your investment won’t generate its expected return. While no one likes looking at his or her investment account and seeing a decline, the uncomfortable truth is that investment risk and return are related.
Generally, an investment with a higher potential return has higher levels of risk. By taking that risk, investors have the possibility of getting a better return. For example, high-yield bonds generate a better return because investors are taking more risk by purchasing bonds whose issuers have a greater probability of defaulting.
Even the stocks of large, well-established companies are at risk of declining at times. In 2022, most stocks were caught in the broad market downdraft.
In most market cycles, individual stocks generally tend to follow the market’s direction, meaning any given stock is at risk of falling along with others. Factors including broad market conditions, geopolitical events, rising interest rates or company-specific events can all contribute to a stock’s decline.
In addition, many stocks have high levels of risk but can also generate high returns.
Small stocks often fall into that high-risk category, as do biotechnology stocks, which can rise and fall quickly based on the success or failure of clinical trial results.
If you’re an investor who likes to dig into the data, standard deviation is a measure of risk the professionals use. It’s a statistical tool that tracks an investment’s performance relative to its expected average return. A stock with a higher standard deviation is one with higher risk.
Why consider low-risk investments?
The reason to consider low-risk investments is simple: They can help stabilize returns and mitigate risk.
Low-risk investments can offer a safe haven during times of market uncertainty, as they provide reliable income in the form of dividend or interest payments.
Capital preservation is another advantage of low-risk investments. If you invest in a speculative stock, the possibility of losing all or most of your money is very real. But if you keep your money in a certificate of deposit (CD) or high-yield bank account, you’ll not only get your principal back but also nab some interest.
But the downside of holding too much of your portfolio in low-risk investments is a lower return when stocks rise, which occurs in about 70% of years. That means if you keep too much money in low-risk investments, you may not generate the return you need for retirement.
Types of low-risk investments
It’s worth understanding the various types of low-risk investments, as each has its own characteristics that may or may not align with your financial goals. The best low-risk investments for you may not be the same as the best low-risk investments for your next-door neighbor.
Here’s a look at some of the most popular low-risk investments.
High-yield savings accounts
Unfortunately, there’s no such thing as high-return, low-risk investments. However, high-yield savings accounts have advantages for savers who want to mitigate risk while getting a better return than they could from other low-risk instruments.
High-yield savings accounts, offered by both online and brick-and-mortar banks, do exactly what the name suggests: They offer a higher interest rate compared to traditional savings accounts.
“High-yield savings accounts are great for short-term idle money that doesn’t really quite have a specific purpose yet or for your emergency funds,” says Bob Chitrathorn, vice president of wealth planning at Simplified Wealth Management in Corona, California.
Short-term certificates of deposit
Certificates of deposit, or CDs, are savings instruments with fixed terms. They offer higher interest than standard savings accounts, but the tradeoff is that investors can’t withdraw money before the maturity date without giving up a significant chunk of interest.
As an example, say you have $100,000 that you’ll need in three months for a down payment on a home. Rather than put that money at risk in the market, you decide to put it in a three-month CD to earn some interest without risking the loss of your principal. After the three months, you’ll receive the full interest payment you signed up for.
CDs are typically offered by banks and credit unions, although some brokers and asset managers also have them available for clients. CD terms generally range from three months all the way up to 60 months.
Locking up money in a CD for five years may not be ideal, as you’ll have limited access to your money. You can miss out on opportunities in the stock market, and the interest rate on your CD may not keep pace with inflation.
Money market funds
A money market fund is a type of mutual fund that pools money from multiple investors and buys short-term, low-risk securities, such as Treasury bills (T-bills), commercial paper (unsecured, short-term corporate debt) or CDs and other highly liquid instruments. If you hold cash at a brokerage, it’s generally held in a money market.
Money market funds are not insured by the Federal Deposit Insurance Corp. (FDIC), but they offer higher rates than traditional savings accounts.
If you want easy access to your funds, a money market fund is generally a better choice than a CD.
That makes money market funds suitable for very short-term goals, such as for an emergency fund. You can’t count money market funds among low-risk, high-return investments, but they can be useful in certain situations. For instance, if you want to keep some powder dry in your brokerage account in case you spot an investment opportunity and want to move fast, a money market account is a good vehicle.
Treasury bills
Treasury bills are low-risk investments for a good reason: They’re backed by the United States government, meaning there’s not much chance of default. Also, T-bills have short terms to maturity of one year or less, which also limits risk. Shorter maturities reduce exposure to market fluctuations, which means T-bills aren’t very susceptible to interest-rate changes.
However, you can’t consider T-bills to be high-return, low-risk investments, as their returns are lower compared to other investments. As with many low-risk investments, T-bills aren’t the place to be if you want to stay ahead of inflation.
Treasury notes
Treasury notes, as you might guess by the name, are also issued by the US government. These low-risk investments have fixed interest rates, so they can add some stability to your portfolio and are generally good choices for conservative investors.
The US government sells Treasury notes for terms of two, three, five, seven or 10 years. These notes pay a fixed interest rate every six months until they mature.
On the downside, their yields are lower compared to riskier investments, limiting the growth potential.
Treasury bonds
US government Treasury bonds have longer terms, maturing in 20 or 30 years. While they offer stable returns with fixed interest rates, these longer bonds carry more risk than shorter-term bills or notes.
The reason for that is pretty intuitive: It’s fairly easy to make an educated guess about where interest rates may be a year or two from now. But in 20 or 30 years, well, who knows? Because of that uncertainty, investors are taking more risk with longer bonds. However, that greater risk also means a greater return.
Still, even long bonds don’t generate the return and growth potential of stocks.
Treasury Inflation-Protected Securities
Finally, TIPS, or Treasury Inflation-Protected Securities, are US government bonds whose principal adjusts with changes in the consumer price index (CPI) — a measure of the prices of consumer goods published by the Bureau of Labor Statistics (BLS). The idea here is to ensure that the investment’s real value remains stable, making it a hedge against inflation.
While TIPS provide inflation protection, they offer lower yields compared to other types of bonds.
Corporate bonds
Corporate bonds typically offer a higher return than US government bonds, as there’s no government-sanctioned printing press to pay off debt if the issuer runs into a problem.
“Risk and return are inherently related and not all corporate bonds are created equal,” says Carla Adams, a certified financial planner at Ametrine Wealth in Lake Orion, Michigan.
If you are comparing two corporate bonds and one pays a higher interest rate than the other, there is likely a good reason, Adams adds. Bonds issued by less financially stable companies tend to pay more, as do more risky longer-term bonds.
Prices of corporate bonds will fluctuate based on factors such as interest-rate changes or a change in the credit rating of the issuing company.
“So if you decide to sell prior to maturity you will have to sell at the going market price which may be higher or lower than par, or what you paid for it,” says Adams.
Dividend-paying stocks
While dividend-paying stocks are popular among investors, there’s no such thing as a truly low-risk stock.
Investors may find they’re trading income and stability for the possibility of growth if they tilt their portfolios too far in the direction of dividend-payers. Advantages of dividend-payers include regular cash flow and the potential for dividend increases.
However, these stocks may still be sensitive to economic downturns, putting a dent in their stability. For example, some companies halted their dividends during the pandemic as revenue and earnings decreased, although many have since reinstated their shareholder payouts.
Be careful if you see a stock with a too-good-to-be-true dividend yield. Since a stock’s dividend yield is calculated by dividing its annual dividend payment by the share price, an unusually high yield could be more indicative of a falling stock price than a company’s financial stability.
Low-risk investment | What are they? |
---|---|
High-yield savings accounts | Savings accounts that pay higher interest rates than traditional savings accounts |
Short-term certificates of deposit (CDs) | Savings accounts that pay a fixed interest rate for a set term |
Money market funds | Mutual funds that own short-term, low-risk securities and pay higher rates than traditional savings accounts |
Treasury bills | US debt securities with fixed interest rates and short terms to maturity of one year or less |
Treasury notes | US debt securities with fixed interest rates and terms to maturity between two and 10 years |
Treasury bonds | US debt securities with fixed interest rates and longer terms of 20 or 30 years |
Treasury Inflation-Protected Securities (TIPS) | Government bonds with fixed interest rates and principal values that adjust based on inflation |
Corporate bonds | Debt securities issued by corporations that typically offer higher returns than government debt |
Dividend-paying stocks | Stock investments that make payments to shareholders out of the company’s overall profits |
The pros and cons of low-risk investments
Capital preservation and steady income are among the most popular features of low-risk investments. Investors also appreciate the consistent returns and reduced exposure to market volatility.
However, these investments typically have lower yields than riskier assets, and investors looking for growth might consider whether low-risk instruments are right for them.
If you’re interested in low-risk investments, remember to balance your risk tolerance with your financial goals, since low-risk investments may not keep pace with inflation.
While the income from these investments is a big advantage, especially during equity market downturns, a heavy allocation into low-risk investments may result in a lower return than you need.
Investment type | Pros | Cons |
---|---|---|
Lower-risk investments | Provide reliable income via interest or dividend payments | May not keep pace with inflation and cause a portfolio to underperform |
Allows for capital preservation and may protect against market volatility | Not always as liquid as higher-risk investments | |
May be federally insured or backed by the federal government | May require you to keep money locked up for a long time | |
Higher-risk investments | Provide higher return potential as well as income via dividends | Potential to lose some or all of your investment |
Generally highly liquid and easily exchanged for cash | Not federally insured or backed by federal government | |
Potential to outpace inflation and meet capital needs in retirement | May be more sensitive to economic downturns |
What to consider before making a low-risk investment
Before making a low-risk investment, it may help to hire a financial planner to help you understand how much risk you’ll need to take to generate the return you need.
Also, consider capital preservation. If you take too much risk, you stand to see larger drawdowns than you might expect. That’s where lower-risk investments come in. They can help you maintain principal so you’ll have funds to invest another day.
Investors who are too narrowly focused on the chance to earn higher yields, particularly in the current higher-rate environment, may face opportunity costs (a loss of potential gains from other investments not selected) when it comes to growth. It’s crucial to understand the balance between growth, income and capital preservation.
Frequently asked questions (FAQs)
To balance your portfolio with low-risk investments, consider allocating a portion of your assets to investments like government bonds or dividend-paying stocks.
But also include higher-risk growth investments, such as equities. Some types of stocks, such as those in the technology sector, are often among the market’s fastest growers, and you may want to balance low-risk investments with these securities.
When choosing a low-risk investment, consider the holding term. For example, if you need access to the money in three months, choose a more liquid investment, like a bond, instead of a CD, in which your money is locked up for a set period. Also, consider whether you are incurring an opportunity cost by foregoing higher-risk investments that could create better portfolio growth.
Returns from low-risk investments, like government bonds, tend to be modest. Some low-risk choices, like CDs or high-yield savings accounts, can be reliable ways to generate a better return than you’ll find in a traditional savings account.
In general, expect your low-risk investments to have returns in line with the current prevailing interest rates. But don’t forget: These are usually below the potential gains from higher-risk investments.
As a general rule, low-risk investments return less than other investments, such as growth stocks or stocks with smaller market capitalizations. On the flip side, low-risk investments can provide a more reliable way to create income through interest or dividends.
Also, low-risk investments like bonds can help mitigate the volatility of stocks and preserve your funds when the stock market heads south.