Risk-Averse Investor's Guide To Smart Investing

Risk-averse investors tend to avoid volatile investments, instead seeking out low-risk opportunities that preserve their capital. While this approach can help investors avoid losses, it also means choosing investments with lower average returns. So, how should you invest if you are too risk-averse?

Savings accounts

• Basic Savings Account: Also known as a passbook savings account, this is a simple, easy-to-use, low-risk account with a lower rate of return. It is suitable for beginners who want to learn about earning interest and saving money. Transactions are recorded in a passbook or issued in a statement. Funds of up to $250,000 are insured by the Federal Deposit Insurance Corporation (FDIC), making this a good choice for investors seeking a very low-risk and easily accessible savings account.
• High-Yield Savings Account: These accounts offer higher interest rates compared to traditional basic savings accounts. They are often accessible online and allow for viewing, depositing, and transferring funds 24/7. They may also be accessible through mobile devices such as tablets or smartphones. Deposits in these accounts may be insured by the FDIC or the National Credit Union Administration (NCUA).
• Money Market Savings Account: Offered by banks and credit unions, these accounts provide a higher interest rate than basic savings accounts. They may offer tiered interest levels or fee waivers for maintaining a certain balance. Money market accounts are suitable for investors with savings goals and target dates ranging from a few months to a few years away.
• Certificate of Deposit (CD) Account: CD accounts offer a higher rate of interest than traditional and online accounts by investing a fixed amount for a specific length of time. The longer the term, the higher the interest rate paid. CDs are a good option for individuals saving for a goal with a defined target date, such as a down payment for a home or an automobile purchase.

Certificates of deposit (CDs)

When you open a CD, you lock in a fixed amount of money for a fixed period of time, ranging from a few weeks to several years, such as six months, one year, or five years. In exchange, the issuing bank pays interest. When you cash in or redeem your CD, you receive the money you originally invested plus any interest.

CDs tend to have higher rates than regular savings accounts. They also have lower yields and are less susceptible to interest rate movements than other higher-risk investments.

There are two types of CDs: "brokered CDs" and "bank CDs". Brokered CDs are issued by a bank or thrift institution and are bought in bulk by a brokerage firm to be resold to customers. Bank CDs are offered by banks.

CDs are subject to various risks, including market/interest rate risk, credit risk, and the risk of inflation outpacing the growth of your money. Early withdrawals are possible but may come with penalties.

Mutual funds or ETFs

If you are risk-averse, you may want to consider investing in mutual funds or exchange-traded funds (ETFs). Both are popular ways to invest in a diverse range of securities while reducing the risk associated with investing in individual stocks or bonds.

Mutual Funds

Mutual funds are an established investment vehicle that has been around for a century. They are professionally managed collections of individual stocks or bonds, actively monitored and adjusted to minimise risk and maximise returns. Mutual funds can be purchased directly from the fund provider, and transactions occur at the end of each trading day based on the fund's net asset value (NAV).

Mutual funds offer a wide range of investment options, from broad market funds that replicate the performance of a broad market index to narrow, sector-specific funds. They also cater to different investment strategies, risk tolerance levels, and asset types.

One advantage of mutual funds is that they often have a lower minimum investment requirement, typically a flat dollar amount. They also offer automatic investment plans, allowing investors to contribute regularly and consistently grow their investments. Additionally, mutual funds may provide better customer service, with phone support and other shareholder services.

However, mutual funds tend to be more expensive than ETFs due to their active management and higher operations costs. They may also have higher expense ratios, and sales of securities within the fund can generate capital gains taxes.

Exchange-Traded Funds (ETFs)

ETFs are newer to the investment arena, having debuted in 1993. Like mutual funds, they are baskets of individual stocks or bonds but are usually passively managed, tracking market indexes or sector sub-indexes. ETFs can be traded on the open market, just like stocks, providing intra-day liquidity and real-time pricing.

ETFs offer similar diversification benefits to mutual funds, spreading investments across various asset classes, sectors, and geographies to reduce the impact of any single security's performance. They also tend to be more tax-efficient than mutual funds due to their passive management and the way they are traded.

ETFs typically have lower investment minimums, requiring only enough money to buy a single share. They also provide more control over the price of trades, allowing for more sophisticated order types. However, ETFs do not offer automatic investment plans, and transactions must be done manually.

Both mutual funds and ETFs are suitable options for risk-averse investors. Mutual funds may be preferable if you want a more hands-off approach, with automatic investment plans and better customer service. ETFs, on the other hand, offer more liquidity and control over trades, along with potential tax advantages. Ultimately, the choice depends on your personal goals, investment style, and level of desired involvement.

Individual investment-grade bonds or bond funds

If you are a risk-averse investor, individual investment-grade bonds or bond funds can be a good choice for you. These are less volatile and more likely to allow investors to recover their money.

Investment-grade bonds are those that are considered to have a lower risk of default. They are issued by companies with a strong financial track record and are rated by major credit rating agencies. The highest rating given to such bonds is AAA, indicating minimal credit risk and strong creditworthiness.

Bonds issued by stable governments and healthy corporations are considered the safest. These bonds have the highest AAA rating and, in the worst-case scenario of bankruptcy, bondholders are prioritised for repayment. Municipal bonds, issued by state and local governments, have an edge over corporate bonds as they are generally exempt from federal and state taxes, resulting in a higher total return for the investor.

Bonds do come with risks, however. For example, Russia defaulted on some of its debts during a financial crisis in 1998. It is important to note that even with low-risk investments like bonds, there is still a chance of losing money.

Bond funds, on the other hand, are a type of mutual fund or exchange-traded fund (ETF) that invests primarily in bonds. They provide diversification by holding a variety of bonds from different issuers, reducing the impact of any single bond default. Bond funds are managed by professionals who make decisions about which bonds to buy and sell, making them a more hands-off investment option compared to individual bonds.

When investing in individual bonds, it is important to conduct thorough research and consult with a financial advisor to understand the risks and rewards fully.

Treasury inflation-protected securities (TIPS)

The principal value of TIPS rises as inflation rises, while the interest payment varies with the adjusted principal value of the bond. The principal amount is protected since investors will never receive less than the originally invested principal. TIPS are issued with maturities of five, ten, and thirty years and are considered a low-risk investment because the US government backs them.

TIPS can be purchased directly from the government through the TreasuryDirect system, in $100 increments with a minimum investment of $100, and are available with the aforementioned maturities. Some investors prefer to get TIPS through a TIPS mutual fund or exchange-traded fund (ETF). However, purchasing TIPS directly allows investors to avoid the management fees associated with mutual funds.

TIPS are important since they help combat the inflation risk that erodes the yield on fixed-rate bonds. Inflation risk is an issue because the interest rate paid on most bonds is fixed for the life of the bond. As a result, the bond's interest payments might not keep up with inflation. For example, if prices rise by 3% and an investor's bond pays 2%, then the investor has a net loss in real terms.

TIPS are designed to protect investors from the adverse effects of rising prices over the life of the bond. The par value—principal—increases with inflation and decreases with deflation, as measured by the Consumer Price Index (CPI). As mentioned earlier, when TIPS mature, bondholders are paid the inflation-adjusted principal or original principal, whichever is greater.

TIPS are ideal for conservative investors who prioritise capital preservation and seek to minimise risk. Since TIPS are backed by the US government, they are considered one of the safest investment options available. For this reason, institutional investors such as pension funds and insurance companies often use TIPS to match their long-term liabilities with inflation-protected assets to ensure they have future cash flow.

Frequently asked questions