Can investments be risk-free?


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If you've been paying attention to your financial advisers and 401(k) plan administrators, you've probably heard at one time or another that as you approach retirement age, you should move your money from investments designed to provide growth and return on principal to lower-risk investments designed to keep your assets safe when you need them most. But can investments ever be truly risk-free?

An investment is essentially any means or strategy employed in the hopes of turning an existing amount of money into a larger amount of money. So an interest-bearing savings account might be considered an investment (just not a very high-return investment), but hiding your cash in a cookie jar would not.

Risk can come from factors beyond the control of an individual business or investor, such as political and regulatory issues, the everyday ups and downs of the stock market, or widespread economic trends such as recessions or depressions. Risk can also be the result of mismanagement, deceptive practices or other failure within a company. And an investor's failure to accept at least a small level of risk can even become a risk in itself.

So what kinds of investments are generally considered risk-free, and does the label ever truly apply? Read on as we take a closer look at several investment options that are frequently described as "safe" in our quest to determine whether investments can in fact be risk-free.

Low-risk Doesn't Mean No-risk

Certificates of deposit, or CDs, offer a guaranteed interest rate for a set time period, commonly six months, one year or five years. CDs are FDIC insured, and they typically pay higher interest rates than savings accounts in return for locking your money in for the contracted amount of time -- the longer the term, the better the interest rate. While some banks go as far as to promote "risk-free CD" products, even these so-called "safe" options involve risks associated with inflation and reduced liquidity that you will want to consider before you invest.

Although they often pay more than standard savings accounts, CDs offer a lower average rate of return than more aggressive investments. If you find yourself locked into a multi-year CD as inflation and interest rates rise, it may actually cost you to keep your money there. The shorter the term, the lower the inflation risk, but the lower the interest rate, too. And if you find yourself needing to cash in your CD before the contracted term, you will pay a penalty equal to some or all of the interest generated, and possibly additional withdrawal fees, depending on your specific contract.

Since savings accounts are insured by the FDIC (up to $250,000), the risks associated with this investment option have to do with what your money isn't doing, as well as with the cost of maintaining the account itself. Savings interest rates are typically low, and bank charges and minimum balance fees can quickly erode any earnings. In addition, the earnings you manage to accumulate will be taxed as interest income. And as with any low-return investment, you run the risk that your returns won't keep up with the rate of inflation.

The term money market applies to two types of low-risk investment that are actually quite different from one another [source: Bernard]. A money market fund is a mutual fund that invests in low-risk (but not risk-free) securities. A money market deposit account, similar to a savings account, is an FDIC insured interest-bearing bank account. As with savings accounts, money market accounts carry the risk of losing value to inflation and account management fees.

With fixed annuities, an insurance company or other financial institution offers investors a certain rate of return for a specified time frame on whatever money they invest. While the returns are typically higher than a savings account or CD, the up-front investment can be significant and the funds invested are not insured by the FDIC, so if the company issuing the annuity fails, the investor is out of luck.

The options we've covered so far all carry some level of risk, however small it may be. But one government-backed investment option is widely considered the closest thing there is to risk-free. What is it? Read on to find out.

The Closest You'll Get to a Guarantee

U.S. Treasury bills are considered truly risk-free because they are backed by the credit of the U.S. government.
U.S. Treasury bills are considered truly risk-free because they are backed by the credit of the U.S. government.
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More than any other low-risk investment, U.S. Treasury bills, or T-bills, are considered to be truly risk-free because they are backed by the full faith and credit of the U.S. government [source: Bankrate]. Investors buy T-bills at a small discount off the face value, and then sell the bill back to the government at full face value upon its maturity date. While the rate of return is relatively low, T-bills are available in short terms ranging from four to 52 weeks, reducing the inflation risks associated with locking up money at a low rate for an extended period of time.

While some analysts and academics argue that T-bills carry at least a small, theoretical risk that the U.S. government might default on its loans, this investment vehicle is so widely regarded as safe that the 90-day T-bill is used as the benchmark for something called the "risk-free rate of return," that is, the interest that an investor would expect to earn from an absolutely, positively risk-free investment [source: Schmidt, Investopedia]. The risk-free rate of return is only theoretical, but it is used to determine acceptable risks, prices and interest rates for higher-risk investments [source: Schmidt].

Of course, if you really want to keep your money where you can see it and access it any time, there's always the old trick of stuffing it under your mattress. Technically this one isn't an investment at all, since an investment by definition seeks to turn an existing amount of money into a larger amount of money, and the goal of hiding money in your mattress is simply to protect the cash you've already got.

It's true that the money you hide in your mattress will be safe from Wall Street crashes, bank collapses and most government conspiracies, but hoarding cash this way leaves you vulnerable to the dangers of theft, fire and inflation. If your nest egg isn't growing at least at the rate of inflation, that money you stashed years ago will be worth less in adjusted dollars than it was when you socked it away.

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Sources

  • Bankrate.com. "Treasury Securities." (Dec. 13, 2010) http://www.bankrate.com/rates/interest-rates/treasury.aspx
  • Bernard, Tara Siegel. "Money Market Funds Enter a World of Risk." Sep. 18, 2008. (Dec. 13, 2010.) http://www.nytimes.com/2008/09/18/business/yourmoney/18money.html
  • The Consumerist. "Certificates of Deposit Aren't Risk Free." March 9, 2009. (Dec. 9, 2010.) http://consumerist.com/2009/03/certificates-of-deposit-arent-risk-free.html
  • Couch, Christina. "CD savings accounts offer stable returns." Bankrate.com. Dec. 5, 2010. (Dec. 9, 2010). http://www.bankrate.com/finance/investing/cd-savings-accounts-offer-stable-returns.aspx
  • Schmidt, Michael. "How Risk Free Is The Risk Free Rate Of Return?" Investopedia. (March 1, 2011) http://www.investopedia.com/articles/financial-theory/08/risk-free-rate-return.asp
  • U.S. Department of the Treasury. "Treasury Bills in Depth." (Dec. 13, 2010.) http://www.treasurydirect.gov/indiv/research/indepth/tbills/res_tbill.htm