Why there's no such thing as risk-free investing

  @Money October 10, 2012: 1:12 PM ET
NEW YORK (Money Magazine)

What is the best no-risk way to invest my $500,000? -- R.S., Las Vegas, Nevada

Sorry, but neither I nor anyone else can give you a no-risk way to invest $500,000, or any other sum.

All investing involves taking some form of risk, even if it's not apparent. And while you may be able to sidestep one threat by choosing a particular type of investment, you will still leave yourself open to a different kind of danger.

Here's an example. When investors say they want a low- or no-risk investment, they typically mean they want to protect the value of their principal and any interest or other investment earnings. Even if the economy and the markets go kerflooey, they want to know their account balance won't drop.

That assurance is easy to get. Just put your $500,000 in FDIC-insured savings accounts. As long as you spread your money among several banks or otherwise take care that federal deposit insurance will fully cover principal and interest, you can rest easy. FDIC insurance is backed by the full faith and credit of the U.S. government after all. So unless you envision some sort of apocalypse that would force Uncle Sam to renege on his obligations, you don't have to worry about losing a cent.

However, since bank accounts, Treasury bills and comparable cash-equivalents are so secure, they typically pay relatively modest returns. Their annual yields have been particularly low the past year or so, well below 1% on average. By keeping your dough in such accounts, you're virtually guaranteeing you'll earn a very low rate of return. And that leaves you vulnerable to other risks.

For example, if you're still investing for a retirement that's some years down the road, keeping your savings in low-yield investments could so stunt the long-term growth of your nest egg that you would have difficulty maintaining your standard of living in retirement.

Related: Ground rules for retirement investing

Conversely, if you're nearing or have already entered retirement and are counting on withdrawals from your $500,000 to pay living expenses, a meager return on your savings would force you to keep those withdrawals to a very modest level -- say, an initial 2% to 3% of your portfolio's value, or about $10,000 to $15,000, which you would then increase by the inflation rate each year to maintain purchasing power. Pull out more, and you would run a very high risk of running out of money early in retirement.

You can protect yourself against the risk of earning inadequate returns by investing your 500 grand in a diversified blend of stock and bond funds. There's no guarantee, but over the long run you're likely to earn several percentage points more a year than you would in bank accounts and similar "safe" investments.

For the 20 years to the beginning of this year, for example, stocks and bonds beat cash equivalents by 4.6 and 3.1 percentage points a year, respectively. So the odds are good that divvying up your money between stock and bond funds will leave you with a larger nest egg when you're ready to retire -- and allow you to draw more without running through your savings too early.

Low-risk investing: Is it worth it?

By owning stocks and bonds, however, you're leaving yourself open to the danger that your savings will take a hit in the short-term. During the severe market downturn in 2008, for example, even a conservative portfolio of 50% stocks and 50% bonds would have lost 16%. Granted, such a portfolio would have recouped nearly all of that loss the next year. But for someone concerned about the security of his savings, a 16% drop could be pretty unnerving.

I could go on and on with other types of risk, but you get the idea. No investment can act as an impregnable shield that protects you from all possible harm.

Given that reality, how should you invest your $500,000?

Start by realizing that while you can't totally eliminate all threats, you can at least gain some protection by taking on several different risks simultaneously.

You'll no doubt want to have money set aside in a secure place so it will be available in full no matter what happens in the market. But unless you plan on spending all your savings in the next few years, you don't have to put it all in such a secure place.

So figure out how much you'll need to tap over the next couple of years -- $50,000, $100,000, whatever -- and invest that amount in an FDIC-insured account. That way, you'll have access to the money you'll really need in the short term without subjecting the whole shebang to the prospect of anemic long-term returns.

Related: Should I quit my job and travel?

Since you won't need the rest of your dough immediately, you can afford to take more risk and shoot for higher returns. If you're investing all or most of the remaining amount for retirement, you can divvy it up between stock and bond funds, depending on how far you are from retirement. If retirement is still a couple of decades or more away, you might want to invest, say, 70% or so in stock funds and 30% in bond funds. Such a mix will get whacked during market setbacks, but your savings will have plenty of time to bounce back.

If retirement is much closer or you're already retired, stability is a higher priority, although you'll still want some growth. So you may want to scale back your stock exposure to say, 50% or even less and keep the rest of your portfolio in bonds. This will give your nest egg more of a cushion should the stock market head south.

Bottom line: You can't eliminate all risk when investing, and the more you focus on avoiding just one peril, the more vulnerable you'll be to others. By diversifying smartly, you should be able to protect yourself adequately against a variety of risks, and lower the chances that any single threat will do your portfolio in. To top of page



Join the Conversation
Overnight Avg Rate Latest Change Last Week
30 yr fixed4.41%4.44%
15 yr fixed3.33%3.31%
5/1 ARM3.34%3.55%
30 yr refi4.39%4.41%
15 yr refi3.31%3.30%
View rates in your area
 
Find personalized rates:
Rate data provided
by Bankrate.com
Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.