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Zero to Minimal Risk Investments

If you haven't already done so, you might want to read another article here on the ITS: FYI page entitled "Risk Tolerance"-either before or after you read this one-and score yourself on the ten items of the questionnaire. Doing that will help you decide the level of risk you are comfortable with in making investments. In that article I used terms such as "higher or lower" related to risk tolerance, and "more conservative or less conservative" related to investment choices.

In this current article I'll write about some of the different interest bearing instruments available, all of which represent the lower risk and conservative end of a continuum of possible placement for invested money.

In a very real sense, when you make investments you get paid for taking risk. High risk, high return, and low risk, low return. For the most part, (there have been some exceptions as with every rule), with low risk conservative investments we can't expect a high return. Here we'll talk about some of the interest bearing investments in terms of safety, amount of study time, and amount of management time required to use them.

Taking the last two points in the above paragraph first, there is minimal study time or management time needed to make use of interest bearing instruments. Related to study time, I guess you could shop around for a day or two to find the best interest rates and gain a half percent or so, but it's not something you have to spend much time doing. Related to managing these investments, little time is needed beyond reading your statements when they come to you. So that leaves safety and return for discussion. We'll find out about comparative returns in a couple of minute and deal with safety here.

Zero Risk Investments:

Treasury Issues:

United States treasury bills and treasury notes are issued by the Federal Government and the risk of losing you money investing in them is so miniscule as to be nonexistent. The likelihood of the U.S. government going belly up and defaulting is zero. Won't happen, so treasury issues are as safe as investments can get.

Treasury bills come in multiples of $1,000, (the minimum is $1,000), and are bought at a discount as opposed to paying interest at regular intervals. In effect, the interest is paid to you immediately and you get your principal back when the issue matures. For example, if you buy a one year treasury bill directly from the Federal Reserve and the interest rate offered is 5.0%, on a $1,000 Treasury bill, you would send in $1,000. Shortly thereafter your bank account would be credited for $50, (the interest due you), and then credited again at the end of one year for $1,000, (your principal.) You are getting your interest up front.

Treasury notes are, in effect, bonds and pay interest at regular intervals with your principal being returned to you on maturity.

You can buy Treasury issues directly via the Web by going to www.publickdebt.gov and also through the investment officer at most large banks.

Savings Account and Certificates of Deposit:

Passbook savings accounts and CDs are also very safe. The Federal Deposit Insurance Corporation (FDIC) insures depositor funds against bank and savings institution failure, and came into being after the Great Depression when many banks failed because depositors attempted to withdraw all their funds at one time. The FDIC insures accounts to a limit of $100,000 per depositor per insured bank. The term "depositor" in the foregoing refers to accounts held by one person as identified by social security number. So, for example, if you have a savings account of $25,000 and hold a Certificate of Deposit of $80,000, (totaling $105,000) $100,000 would be insured, but $5,000 would not be insured.

It is possible to have more than $100,000 of FDIC insured deposits because the same person can have accounts with more than one bank-the "per depositor per insured bank" in the above paragraph. Further, spouses can have separate accounts, each with his or her social security number only, at the same bank and both would be insured to the $100,000 limit.

Minimal Risk Interest Bearing Investments:

Bond and Money Market Mutual Funds:

Bond mutual funds and money market mutual funds are not insured by the FDIC, or any other agency, and do therefore entail some risk. The risk is not so much related to bonds or the money markets themselves, but to the financial management company you are working through. If the mutual fund management company you use is large, strong, highly reputable, and has been in business for many years, then your funds should be safe.

Individual Bonds:

For bonds purchased outside of a bond mutual fund it is important to choose what are called "investment grade" bonds. Standard Poor's and Moody both rate bonds that are offered to the public and AAA (Triple A) rated bonds are considered investment grade.

With bonds, you are loaning money to a business for a specified-and variable per the bond selected- period of time and are paid interest at regular intervals, usually quarterly or monthly. The risk associate with bonds is that the business could default on interest payments or the entire bond you hold as, for example, in the event of a bankruptcy. Therefore, you will want to buy only bonds of businesses that are large enough and stable enough to assure you'll get your money back with interest.

Avoid bonds that are not investment grade. There is a rating called "junk bonds" that will offer significantly higher interest rates, but they are called "junk" for a reason, which is that the company offering them is also significantly less stable and the odds of default are significantly greater. Avoid junk bonds, period.

Returns for Interest Bearing Instruments:

Now let's look at returns we can expect from some of the investments above. We'll look at history from 1970 through 2004, and I'll use a table format to show the figures. The table won't be big enough to include absolutely everything so we'll show bank savings accounts, three month Treasury Bills representing short term interest rates, five year Treasury Notes representing long term interest rates, and Triple-A corporate bonds representing loans to stable businesses. I'll show decade averages for each and also show the Consumer Price Index which is probably the most common measure of inflation. We can then compare returns with inflation rates and see how we might fare using these investments.

Conservative Investment vs. CPI

As you can see, some time periods were better than others for interest bearing instruments. I'll use another table that shows how each compares to inflation by decade and then overall. A number shown inside arrows means the percentage less than the inflation rate, and a number without arrows means the percentage above the inflation rate.

We see that in the 34 year of this study interest bearing investments pretty well matched inflation, and with long term treasury notes and AAA-rated bonds we would've gotten a little growth of capital. That's OK if we understand that our goal with these kinds of investments is NOT growth of capital, but rather PRESERVATION of capital. We're not going increase our money a lot using them, but we are going to keep what we have and what we have will keep pace with inflation, thereby preserving buying power.

I mentioned above that there are exceptions to every rule, including this one, so I'll tell you a short story. About 1982 I was attending a five day conference and met a woman at breakfast one morning who told me she'd just gotten a $200,000 inheritance that she invested in a five year Certificate of Deposit at a 20% interest rate. Wise woman that she was, at the end of the five years her CD grew to $497,664. Not bad!

As I said, this is an exception, and it was brought about by extremely high interest rates and high (double digit) inflation rates. The rule we can derive from this story is that the time to buy long term CDs, long term treasury issues, or long term bonds is when interest rates are exceedingly high-which, hopefully, we won't see in our lifetime again.

arley