A few weeks ago, I did a podcast with the Director of Financial Planning of Alliance Wealth Management, Andrew Rogers. Our main topic of the day was principal protection – as in, choosing investments that protect your nest egg from losses while promoting at least some growth.
Even though it’s been a few years, the financial crisis of 2008 and 2009 in still fresh in everyone's minds. And as the Dow Jones flirts with all-time highs, it’s important for investors – especially those nearing retirement – to avoid a loss of capital due to regular market fluctuations.
This is where principal protection comes in. By and large, investing for principal protection is the best way to avoid the catastrophic losses that come with any market downturn. The notable downside that comes with this strategy is the gains you'll sacrifice in exchange for more security.
7 Investment Options for Principal Protection
But, how do you invest to protect your principal? At the end of the day, the best option for your money depends on how much time you have, how much risk you're comfortable with, and your overarching investment style.
Although I have my own opinions, I spoke to several financial advisors to get their take on your best options as well. Where can the average investor stash their money without losing their shirt? And, how does someone approaching investing for growth with reduced risk? Here’s a compilation of the many responses I received:
#1: Online High-Yield Savings Accounts
According to San Diego Financial Planner and founder of Define Financial Taylor Schulte, high-yield savings accounts opened online can be a smart option depending on your situation.
“Your money is liquid and it’s protected by FDIC insurance,” he says. When Schulte speaks of FDIC insurance, he’s alluding to the fact that Federal Deposit Insurance Corporation (FDIC) insures individual bank deposits up to $250,000.
While the average annual interest rate is only around 1% – 2% with online savings accounts, it’s still much more than you are getting at your brick and mortar bank. And since inflation is low, earning just 1-2% won’t leave you that far behind in term of your money's value, either.
Related: Top 9 Best Online Savings Accounts
#2: Money Market Accounts
A Money Market Account is a hybrid bank account that offers some of the benefits of a savings account, but the potential for higher returns and better access to your money. By opening a money market account at your local bank or online, you might score a better interest rate, get access to checks you can write against your account, and protect your principal in its entirety.
If you don’t want to use a traditional bank, you can open a money market account with TD Ameritrade or another brokerage firm that offers online account management. Like with any other bank account, there are a ton of options at your disposal.
You can open a Money Market account with TD Ameritrade, Scottrade, and E*TRADE or with the same banks that offer high interest savings accounts. You won't earn a lot of interest on your investment, but you won’t have to worry about losing vast amounts of your principal, either.
#3: Certificates of Deposit (CDs)
According to Joseph Carbone, Jr., CFP Founder and Wealth Advisor of Focus Planning Group, Certificates of Deposit (CDs) are another option to consider when you’re interested in principal protection.
“In today’s environment, they are really one of the only true vehicles that is protected because the issuing bank is backed by FDIC insurance,” says Carbone.
The tradeoff, says Carbone, is the fact you won’t earn a lot of interest on your money. It is possible to improve your average return, however, if you’re willing to buy CDs with a longer term.
Many experts also suggest laddering your CDs to increase your potential for greater returns down the line. With laddering, you buy CDs of varying lengths with the goal of having your investments mature at regular intervals. This way, all of your money isn’t locked up at once and for the same stretch of time, making it possible to purchase new CDs with higher interest rates if they are available.
#4: Municipal Bonds
Municipal bonds are yet another option for investors who want the potential for growth, but principal protection above all else. When you purchase a municipal bond, you’re actually providing income to your state or local government. And since most state and local government agencies exempt income taxes on these bonds, you’re also saving money on taxes.
If you trust the government to repay monies borrowed, you can consider municipal bonds a fairly safe bet. Some municipalities and state governments have declared bankruptcy and defaulted over the years, but it’s extremely rare.
Interest rates for municipal bonds vary, but you can usually earn 3% or more on your money. All things considered, the benefits and reduced risk municipal bonds offer make them a smart option for any investor who needs principal protection.
#5: U.S. Savings Bonds
There are two main types of savings bonds to consider – Series I and Series EE. While each bond type works in its own way, both offer principal protection with little risk of default.
With Series I bonds, you’ll get a fixed interest rate return and an adjustable inflation-linked return. While the fixed-rate never changes, the other component of your return is adjusted every six months – sometimes up and sometimes down.
With Series EE bonds, you have a fixed rate of return that is added to the bond automatically each month. While rates are low right now, the U.S. Treasury promises to double the value of your bond if you hold it 20 years until it reaches maturity. If you don’t hold a Series EE bond to maturity, you’ll get the fixed rate of return minus early withdrawal fees.
Either bond option can be smart for anyone angling for principal protection with some potential for growth. You can purchase both types of bonds directly through TreasuryDirect.gov.
#6: Treasury Inflation Protected Securities (TIPS)
The U.S. Treasury offers another low risk bond option to choose from. Treasury Inflation Protection Securities – also called TIPS – offer a fixed interest rate that doesn’t change throughout the life of the bond plus built-in inflation protection that is guaranteed by the U.S. government. The second component of this investment – the built-in inflation protection – kicks in each time inflation grows to bring your investment’s value up to match the rising inflation rate.
You can purchase TIPS individually or as part of a mutual fund that invests in a basket of TIPS. If your goal is principal protection, then investing in TIPS individually is likely your best move.
Want to protect your portfolio from inflation? Purchase TIPS through a great broker like E*TRADE, TD Ameritrade, or Scottrade.
While annuities have gotten a bad rap, at least one financial advisor advocates annuities for principal protection in certain situations. Joseph Carbone of Focus Planning group says he is a big proponent of immediate annuities – mainly because they guarantee an income stream for a certain period of time. The trade-off, he says, is that you lose access to the lump sum of your investment for a specific (and long) stretch of time.
“If someone is not looking for income but is not willing to take any risk, then you could look at a fixed annuity,” says Carbone. “A fixed annuity pays a guaranteed rate of return for fixed amount of time.”
Again, the main problem with annuities is that you are locking up your funds in a historically low interest rate environment, plus any back end sales charges you might face. As with any investment, you should read the fine print and understand all charges and fees before you pull the trigger with an annuity.
Protecting your retirement savings from losses may not be a priority when you’re young. When you’ve got twenty or thirty years before retirement, you should actually expect the value of your investments to rise and fall over the years.
But, as you get older, you learn you no longer have that luxury. Where you once had decades to build your nest egg, you’re now down to a few precious years. This is where principal protection comes in, and why it’s so important to begin with. When you only have a few years to retirement, it’s crucial to protect your money.
As you look for ways to protect your principal, consider some of the options on this list. Ask yourself which investments can help you grow wealth while minimizing your risk, then move forward once you’re ready. And if you need help, make sure to ask a financial advisor for their take on principal protection. When you speak with your advisor, make sure to ask them what they would suggest if you were their parent.
At the same time, you should watch out for self-serving advice from financial advisors who might line their own pockets at your expense. In other words, be wary of financial advisors that push expensive life insurance and annuity products without mentioning other options first.
“Beware of other financial advisors suggesting high-cost, commission-based principal protection products,” says Minnesota Financial Advisor Jamie Pomeroy. Principal protection means actually protecting principal at all costs, not offering a chance at principal protection if the markets behave, and after you factor in absurd costs, he says.
How do you invest to protect your principal? Are there any other investments you would add to this list?