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.
For many that have never invested before, they feel this same apprehensive feeling.
With the rising cost of living, it’s imperative that we invest (preferably with the lowest risk possible) to generate high yield returns.
High rates of return on your investments are wonderful because it means 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 that return.
As you near or enter retirement (or if you are managing investments for your high school senior’s college fund) 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.
Instead, you need to shift to low risk investments. These types of investments will generate a lower return because you aren’t taking as much risk, but you’re okay with that. At this time capital preservation is more important that astronomical growth rates. You need to know your account won’t drop 25% in a year and severely impact your investing goals.
Best Low Risk Investments
When it comes to investing even those targeting low risk, low return investments will 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
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 of time that will not change, no matter what happens to interest rates. You are locked in until maturity of the term length. (You can choose to withdraw from the CD early for a penalty that is equal to 3 months’ worth of interest, usually.)
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 at that specific financial institution are less than $250,000. The government is guaranteeing you cannot have a loss, and the financial institution will give you some 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.
2. Treasury Inflation Protected Securities (TIPS)
One of the lowest risk is called Treasury Inflation Protection Securities or 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 will rise with that inflation rate.
For example, you might 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. That 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 will grow with that inflation and give you a much higher return on your investment.
TIPS can be purchased individually or you can invest in a mutual fund that in turn invests 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.
3. Money Market Funds
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.
4. Municipal Bonds
When a government at the state, or local needs to borrow money they don’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 these bonds, 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 this is 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. US Savings Bonds
US Savings Bonds are similar to Treasury Inflation Protected Securities because they are also backed by the United States 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. They are somewhat similar to TIPS because they have the inflation adjustment as part of the total return. The fixed rate never changes, but the inflation return rate is adjusted every 6 months and can also be negative (which would bring your total return down, not up).
Series EE bonds just have a fixed rate of interest that is added to the bond automatically at the end of each month (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). That equates to approximately a 3.5% return on your investment. If you don’t hold to maturity you will 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.)
Annuities are a point of contention for some investors because shady financial advisors have over-promoted them to individuals where the annuity wasn’t the right product for their financial goals. They don’t have to be scary things; annuities can be a good thing to help stabilize your portfolio over a long period of time.
But be aware and 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 at the end of the day when you purchase an annuity you are making a trade with an insurance company. They’re taking a lump sum of cash from you. In return they are giving 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 and gives you downside protection (with an equity indexed annuity).
If you are getting a form of guaranteed return your risk is a lot lower. Unlike the backing of the Federal government, your annuity is backed by the insurance company the holds it (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. This insurance not only pays out a death benefit to your beneficiaries when you die (like a term life insurance policy), but also allows you to accrue value with an investment portion in your payments. Whole life insurance and universal life insurance are both types of cash value life insurance.
While term life insurance is by far a cheaper option, it only covers your death. One of the best perks of using cash value life insurance is the accrued value can not only be borrowed against 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 being hit with income tax.
Some Middle Risk Investments to Consider
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 to consider to 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 period of time, but one has no dividend and the other pays out 3% per year in dividends, then the latter stock would be 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) and comes with risk that the company may falter and take your investment down with it. A safer bet would be to invest money into a dividend stock mutual fund. With this type of mutual fund 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
Adding on to the dividend stock theme is preferred stock. Preferred stock is a type of stock that companies issue that has both an equity (stock) portion and a debt portion (bond). In the hierarchy of payouts to forms of investments, preferred stock sits between bond payments (which come first) and common stock dividends (which come last).
Preferred stock are 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.
10. Peer to Peer Lending
P2P Lending is a completely different type of investment. Instead of buying shares in a company (and its future profits) you are lending your money to someone else in hopes they will pay you back. This makes peer to peer lending risky if you screen poorly because if you fund a terrible loan, you might not get your money back.
On the other hand if you screen well then 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 having to go through every single loan (which you can still do) they offer an option to where you target a certain rate of return and the company lends out money to a portfolio for you.
One thing to be extremely aware of when lending money to strangers on the internet is how well the company’s collection process is. Lending Club in particular has done a great job in setting up their collection practices in order to protect their investors. (Lend Academy did a great interview with LC’s Head of Collections.)