Face it; money is important. When we get a few dollars ahead the last thing we want to happen is to lose our hard-earned cash to anything. What we need are some risk-free investments. Luckily, I have a list:
Pretty impressive, right? Ok, the title was clickbait but the list is real. Every risk-free investment is part of that list. In short, there is no such thing. Every investment has risk, the trick to investing is to understand the risks of each investment and to be able to determine if the risks are worth the rewards. Let's take a look at the risks and rewards of some popular investments.
I'm Putting My Money in a Safe!
Whether you are talking about a safe, a safety deposit box, a treasure chest in the backyard, or the space under your mattress, there are people who like to keep their money close at hand, outside the view of the banking system and government. Some of these people are hiding ill-gotten gains, but others are ordinary people who earned their money the honest way and paid income taxes on it.
The risks of this investment include misplacing your money or, if you die, no one knowing where it is. If the wrong person gets wind that there is cash on the premises, robbery becomes a risk. Also, the money doesn't grow--while $10,000 would have purchased a nice car when I graduated from college, today's $10,000 car is definitely used.
On the other hand, some families use versions of this investment to save for fun goals. Putting cash saved by economizing in a visible place where the family can see it (and hopefully where others don't) can motivate the troops if you are saving for a special trip or a new toy.
Bank Accounts Are Insured, I'm Putting My Money in the Bank!
Bank accounts are insured up to $250,000 per depositor per bank. You can't lose money unless the federal government goes out of business, right? Wrong. It is true that if you put $1,000 in the bank, that $1,000 plus interest will be there when you go to withdraw it. However, you will have to pay taxes on the interest, and inflation will erode the purchasing power of your principal. As a long-term investment, bank accounts run a substantial risk of not growing fast enough to cover your needs.
The certainty of bank accounts is their strength. If your goals include spending a sum of money in the next 2-3 years, that money should be in the bank. It may not grow between now and then, but you are protected from the volatility of other investments. If your child starts college a year from now, you don't have time to recover from market loses between now and then. The risk of not having the money when the tuition bill comes due two years from now is greater than the rewards of a sensible stock market investment.
How About Bonds?
When you buy a bond, you are lending someone money. If you lend money to the US government, you chance of being paid as promised is very high. If you lend money to a company in financial trouble, your chance of being repaid is somewhat less.
Bonds can be coupon bonds or zero coupon. Holders of coupon bonds are entitled to payment of a certain amount of interest yearly, and repayment of the principal amount when the bond expires. Zero coupon bonds do not pay interest yearly, it accrues and is paid when the principal is repaid.
Bonds carry three risks: Interest rate risk, inflation risk and credit risk.
Credit risk is the risk that the issuer may not be able to repay the loan. The way to mitigate that risk is to invest small amounts of money in many bonds rather than large amounts of money in a few. An easy way to do that if funds are limited is to invest in bond mutual funds or ETFs.
Inflation risk is the risk that your money won't buy what it did when you invested it. A way to mitigate that risk is to buy bonds with a variety of maturity dates so that you regularly have money available to re-invest. Also buying shorter term bonds helps with inflation risk because when inflation goes up so do interest rates. Investing in short term bonds allows you frequent access to your money, so that you can re-invest.
Interest rate risk. As noted above, when inflation rises, so do interest rates. If you purchase a bond today that pays 2% interest, as long as the issuer is financially viable, you will receive your 2% and, in the end, your principal will be returned. However, if inflation rises or something else happens so that similar bonds are paying 3%, if you need to sell your bond, you will get less than face value for it. Why should I buy your 2% bond when I can buy a 3% bond? You have to make it worth my while by lowering the price. In the same way though, if I have a 3% bond and interest rates drop, I can sell it for more than face value. The shorter the term of the bond, the lower the interest rate risk, and the lower the interest, all other things being equal.
Surely You Don't Recommend the Stock Market?
Stocks are not the first thing that comes to most people's mind when "safe" investments are discussed. We all see the news about the stock market going up and down. We have heard of people who have made a mint, and of people who have lost their shirts.
Over the long haul, stocks are the only investment that consistently outpaces inflation and taxes. If you are saving for retirement and not using stocks or stock mutual funds, you run a very real risk of not having enough money. On the other hand, if you need money for something next year, if you invest the money in stocks, you run a very real risk of not having enough money due to a routine short-term drop in the market. In short, stocks are a long term investment, not a place for money you will need soon.
There have been volumes written about how to invest in the stock market and I won't repeat them here except to recommend picking a good low-cost index fund, investing your money and leaving it alone.
I Read on the Internet About a Great New Investment...
You and thousands of other people. Some things to keep in mind when evaluating any investment opportunity:
Risk vs. Reward
In general, the higher the potential reward for an investment, the higher the risk. Lottery tickets have a very low chance of paying off, (and a very high chance of losing all your money) but if your powerball ticket hits, your reward is tremendous. You aren't going to lose money in a bank account, but you won't get much interest either.
Supply and Demand
If the supply of something exceeds the demand for it, those who own it will have to lower the price to increase demand. If the demand for something exceeds the supply, the price of it will go up. Put another way, if you offered me a goose for $20 right now, I wouldn't take it. I don't want one and I don't think I could sell it for more than $20 immediately and I don't want a goose! However, if you proved to me and to others that you had a goose that truly would lay a golden egg, we'd get in a bidding war for it and I'm sure I'd end up paying you more than $20 for that delightful bird.
Normalization
In general things tend to normalize over time. What that means is that if you find a "hot" investment, it probably won't be "hot" for long. If you take a risk and buy XYZ stock when no one else wants it, you'll make a pretty profit when "everyone" discovers that the company is great and starts bidding up the price. However, those who start buying it later in the rally won't make nearly as much; eventually the price of the stock comes into line with the realistic profits of the company.
A good example of normalization and its cousin "supply and demand" is Kickfurther, about which I've written extensively on this blog. During the summer of 2015 Kickfurther was blowing and going. Offers of 10% for six months were not uncommon and some companies offered even more. It was great and those of us who were investing were getting rich fast.
Then those businesses noticed that offers that went live at 4:00 p.m. were fully subscribed by 4:00:20. They did what any sensible business would do, they lowered the potential reward. It was ok with them if it took a full minute for the offer to fill. Slowly the average offered interest dropped. Then the defaults started to hit and investors started to question the viability of the platform. At the very least, they calculated the return necessary to make a profit given the default rate. Offers began to languish unfilled. Interest rates began to rise.
If an investment sounds too good to be true, it probably is.
So, the best risk-free investment? There isn't one. However there are a variety of investment products available, each with its own risks and possible rewards. Pick the right ones for you.
You've made some very important points about risk and reward and the various types of investments. However there is one type of bond that helps to mitigate losses against inflation and that is the I bond which earns interest with a combined fixed rate and inflation rate. It's still not entirely risk-free, but it's a good option.
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