How Do I Avoid the Risk of Stocks?

The inspiration for this week’s post comes from Gaius Plinius Secundus – whose friends affectionately call Pliny. Pliny asks a great question about investing. Pliny says,

I’m nervous about the effect of volcanic eruptions on the stock market. If I need to withdraw money within the next five years, where should I put my cash when I don’t want the risk associated with equities?

You may have noticed that Pliny prefaced his question with, “within the next five years.” He did this because he knows that the greater risk to an investor – on long timelines – is not that they lose their money in the stock market. The greater risk investors face is that their money becomes worth less over time. This is because of inflation.

Short-Term Investments

For shorter investment timelines, when the safety of your money is more important than the fact that the money keeps up with inflation, there are a handful of investment options available, including:

• • • Savings Accounts
    • Certificate of Deposits
    • Government Bonds
    • Money Market & Bond Funds

Short-term investments offer a variety of pros and cons. In particular, short-term investments are currently offering historically low interest rates. The pros and cons of these short-term investments are explained below.

Savings Accounts

The upside of a savings account is that you can earn the market rate – at least for ultra short-term investments. If interest rates rise, so will the investment return of your savings account. That is, if interest rates rise, you won’t be locked into an investment paying yesterday’s lower interest rate. (Investment geeks call this interest-rate risk.) As a bonus, money in a FDIC-member bank savings account is backed by the full faith and credit of the United States government (on amounts up to $250,000).

The downside of putting your money into a savings account is that you’ll only get the market rate on ultra short-term investments. Over the last few years, the interest rate for short-term investments has been quite low.

Certificates of Deposit

Like a savings account, a FDIC-member bank certificate of deposit (CD) offers backing by the United States government. With CDs, you may be able to score a higher interest rate than a savings account. You’re able to do this because the CD gives up liquidity in exchange for a higher return; you’re paid extra for the inconvenience of having your money locked up. (Investment geeks call this the illiquidity premium.) Depending upon the CD, you may be able to get your money back early (before the CD matures). However, this privilege usually comes with the penalty of foregone interest payments.

Individual Government Bonds

With individual government bonds, you’re offered a higher return than most savings accounts (or even some CDs). However, like a CD, you run the risk that interest rates may increase while you are locked into your investment. Consider an example:

Unsatisfied with the meager return offered by savings accounts, Pliny buys a three year bond paying 1.00%. The next day, Mount Vesuvius destroys the city of Pompeii. This scares investors, doubling interest rates to 2.00%. Pliny is now stuck holding a bond paying 1.00%, while savings accounts are paying literally twice that. While he could sell the bond, he would be forced to do so at a loss. This is because no investor would buy Pliny’s bond paying 1.00%, when other bonds are paying a higher rate. Pliny can only make his bond appealing if he sold it at a discount.

Money Market Funds & Bonds Funds

The riskiest non-equity investments discussed today are funds. In addition to interest rate risk, funds are subject to:

• • • Credit Risk
    • Investor Risk (Market Risk)

Money market funds are made up of many short-term investments – not just those investments backed by the United States government. This non-Federal debt includes corporate debt. Corporate debt is subject to credit risk: the risk that the debtor may not end up paying the creditor (you) back.

Investor Risk: Investor risk comes with any mutual fund investment. Investor Risk is the risk that investors will redeem shares in a way that negatively effects the fund. This usually happens when investors stampede out of a fund, forcing the fund manager to sell some investments at a discount. (Whenever you sell something at a discount, it hurts your investment return.)

When it comes to bond exchange-traded funds (ETFs), market risk can similarly hurt an investor’s return – with bond ETF holders fleeing their positions, driving down the ETF price. (Economists call this phenomenon supply and demand.)

If you invest in a bond fund, you may end up with less money than what you start with (because of investor/market risk). By choosing individual bonds, certificates of deposit, or a savings account, (over a fixed-income fund), you can avoid investor risk.

What should Pliny choose?

Consider that as you move from a savings account, to a CD, to an individual government bond, you move into greater amounts of interest rate risk in exchange for a higher return. Any investment you choose should reflect your risk tolerance, and liquidity needs.

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If you’re unsure of how to structure your investments, or if short-term investments are right for you, work with a fee-only financial planner to help you navigate the important variables of your risk tolerance and investment time horizon. Without the conflict of interest stemming from the desire to earn commissions from selling products, a fee-only planner can determine the best solution for your investment needs.

References

Federal Deposit Insurance Corporation. (2014, June 3). FDIC: Understanding Deposit Insurance. Retrieved from FDIC: Federal Deposit Insurance Corporation: https://www.fdic.gov/deposit/deposits/

McCabe, P. (2010, September 12). The Cross Section of Money Market Fund Risks and Financial Crises. Retrieved from The Federal Reserve Board: http://www.federalreserve.gov/pubs/feds/2010/201051/

Swensen, D. F. (2005). Unconventional Success: A Fundamental Approach to Personal Investment. New York, NY: Free Press.