Low-risk investments play an important role for people who may need to access their money fairly soon, and for people who want a stabilizing balance against more risky investments. The question is, what exactly does "low-risk" mean?
If you are looking for low-risk investments, it is important to have a basic understanding of how to define risk, and how different investments fit that definition.
Defining risk for investments
From an investment standpoint, risk is commonly understood to represent the possibility of losing money. That is one form of risk, but there are also other forms of risk that can hurt you even if you never lose a penny. For example, inflation could erode the future value of your savings, or returns could fail to meet your expectations and result in your not having enough money to retire on.
While you should keep those other forms of risk in mind when doing long-term retirement planning, this discussion will focus on the definition of risk as the possibility of losing money, since the idea behind low-risk investments is for them to be there when you need them.
To be absolutely free from the risk of loss, an investment needs to guarantee the return of principal, or the amount you put into the investment. On top of that though, it matters a great deal who is issuing that guarantee.
Savings accounts are bank deposits which do not fluctuate in value. At FDIC-member banks, that value is backed by the U.S. government (as are credit union accounts at NCUA-participating institutions). FDIC insurance limits mean a total of $250,000 per depositor at each institution is protected should a bank fail. So, an FDIC-insured savings account of up to $250,000 can be considered as free from the risk of loss as just about any investment in the world.
Not only is the value of savings accounts protected, but you are allowed access to your money at any time, so you can realize the value of that protection immediately. This is important for investors with immediate needs, such as withdrawing money for retirement expenses.
Savings accounts also pay interest, but only in small amounts that vary according to interest rate conditions. Those rates can vary greatly from one institution to the next, so be sure to shop around for the best savings interest rates.
Money market accounts
Money market accounts are essentially the same as savings accounts. They offer the same FDIC protection, but remember that at any given bank that protection is limited to $250,000 per depositor across all accounts. So, having a $250,000 money market account on top of a $250,000 savings account at the same bank will not gain you any additional protection.
As with savings accounts, money market interest rates vary from bank to bank, so this is another instance where shopping around can really pay off.
Certificates of deposit
A certificate of deposit (CD) is a deposit account where you agree to leave your money at the bank for a specified period of time, in return for which the bank agrees to pay you a specified rate of interest. The longer you agree to lock up your money, the higher your interest rate will generally be with long term CD rates higher than short term rates. For example, 1 year CD rates are generally higher than savings account rates, and 3 year CD rates are generally higher than 1 year rates.
CDs at participating banks are also covered by FDIC insurance up to the $250,000 limit, but here it is important to introduce the idea that your time frame can have a great deal to do with risk. The risk of losing money is different if you need to access that money at any time than if you don't need to touch it for five years. If you may need your money at any time, a CD may carry some risk because withdrawing from it before it has run its full term may result in a costly penalty. However, if you can afford to wait the full term of the CD, it can offer guaranteed safety with a higher yield than savings or money market accounts.
US Treasury securities
Besides FDIC-insured accounts, U.S. Treasury bills, notes and bonds are also backed by the U.S. government. However, the guarantee is that they will pay interest at a stated rate and can be redeemed at face value at their maturity date. Between now and maturity though, they are subject to changes in market value, and longer-term Treasuries like 30-year bonds can fluctuate in value quite widely.
Here again, your time frame plays a role in how risky this vehicle is. If you can afford to wait until the maturity date before selling your Treasury security, you will know what you are going to get. However, if you may have to sell sooner than that, you risk taking a loss.
Annuities are included here because they are often viewed as low-risk investments. However, they are not necessarily as low-risk as they seem, nor are they as low risk as most of the vehicles described above.
Annuities are contracts issued by insurance companies. They offer a stream of payments in retirement in exchange for either a lump sum or periodic payments in advance. They also typically include an insurance component, which would leave a specified amount to your designated beneficiary if you die before receiving your benefits.
Still, there are risk factors involved. Though marketed as "guaranteed," annuities are only guaranteed by the insurance company issuing them. Given that these are investments people count on for a very long time into the future, understand the health of any given insurance company can change drastically over such a long time frame.
Also understand the distinction between fixed and variable annuities. If you are looking for a specific level of income, make sure to sign up for a fixed annuity.
As for return, before signing up for an annuity, figure out whether you could acquire the same insurance and income benefits more cost-effectively by signing up for life insurance and separately investing the remainder. Given that annuities often have high fees, they do not always offer the best return on your money.
Annuities are one of many examples of financial products that use the word "guarantee" rather freely. A fundamental rule of low-risk investing is that if the guarantee is offered by anyone other than the federal government, you have to evaluate just how heavily you want to depend on it.