Risk and reward follow one another. It feels great to make money, but terrible to lose it. After several years of rising stock prices, it’s easy to think that money just grows on trees. All it takes is one look back at 2009 to see just how bad things can get.
Conservative investments have a place in everyone’s portfolio, just as riskier investments do, too.
Common Conservative Investments
Here are some of the more conservative investments that you should consider for your portfolio:
Certificates of deposit – Nothing says conservative quite like a CD. A certificate of deposit is a great way to protect your money from losses while enjoying interest rates higher than a savings account. Just like a savings or checking account, CDs are insured by the FDIC for up to $250,000 per person. Unfortunately, low risk has its downside: the current yield on a 5-year jumbo CD (more than $100,000) sits at 1.75%. Rates are much lower on smaller CDs, ranging up to 1.5% for investment dollars locked up for five years.
Money market accounts – Another step up from a savings account is a money market account. Easily liquidated and closed, these accounts yield only a small bit more than your average savings account. Money market accounts are tough to find – banks don’t want to open them because there’s not much money to be made at current market interest rates. From a savers’ perspective, money markets are a great place to store money might not need now, but would like to use in the future.
Bond funds – Investing in the debt of a public company or government is a big business. While you won’t get rich in bonds, they’re in the safest part of the financial market. In the event of a bankruptcy, bondholders are paid out first, well before stockholders get a claim on the company’s assets. Plus, debt has a known expected return: a bond will pay out face value at maturity and coupons (interest) until the day it matures. The “safest” of bond funds are invested primarily in government debt (US Treasury bond and bills) and investment-grade corporate debt with a short time to maturity.
How conservative investments fit in your portfolio
Timing in the market is incredibly difficult. Stocks looked cheap in 2009, but it’s always easy to say that in retrospect. They weren’t so cheap when investors had to balance the idea that the world economy was coming to a crawl.
That’s why conservative investments are so important as a balance to riskier investments. Stocks may provide the highest returns in the long-run, but in the short-run, stocks also provide the largest one-year losses.
Conservative investments are not intended to make you money. You won’t have a huge retirement windfall to spend by investing in risk-free assets that yield 1-2% per year. You will, however, protect what you have against losses, and earn the opportunity to later rebalance when your target allocation falls off the mark.
A very simple, but good asset allocation model is based on your age. Subtract your age from 100 and put the resulting amount as a percentage in riskier investments like stocks. The balance should go to conservative investments like CDs, investment-grade bond funds, or money market accounts. A 28 year old who follows this model would have 72% of his or her assets in stocks, and 28% in conservative investments.
Saving the tax-efficient way
You can only put so much into a 401K or IRA in any given year. The limit in 2013 is $17,500 for 401Ks and $5,500 for an IRA. These are very valuable tax shelters that you shouldn’t use up on your conservative investments.
A retirement account grows tax-deferred. For that reason, they’re best saved for the investments with the highest potential returns (read: not the conservative part of your portfolio). Having a cash pile outside of retirement in CDs, money markets, or bond funds serves as a bumper in the worst case scenario; an emergency fund of sorts. Cash that can be easily accessed at any time is invaluable as an asset, since retirement savings can be hit with withdrawal fees and IRS penalties. Why lock cash up only to pay a penalty if you need it earlier than expected?
Short duration bond funds, money market accounts, and CDs make for an excellent place to store capital safely, enjoy a reasonable return, and protect yourself from downside risks. Keeping at least your age as a percentage in cash and cash equivalents is a good way to bomb proof a small part of your portfolio. While none of these investments will make you rich, they won’t make you poor, either.
Like you mentioned, it is all about balance. It is wise even for investors who are willing to take more risk to include some portion in conservative investments.