Low-risk investments have inherently lower profit potentials than those with higher risks. No investment is risk-free–even insured bank accounts and top-rated bonds. Traditional low-risk investments have the potentially large risk of losing value because of fluctuations in currency values and the process of inflation, which decreases the value of the investment in which the currency is denominated.
Significance
Even if an account or financial instrument is insured by the government and has a low risk of going into default, and appreciates every year in nominal terms, there is still no guarantee that the gains will beat inflation. The Consumer Price Index published by the Federal Reserve estimates annual inflation rates, but it is not an objective metric for determining the exact rate of inflation. Due to the complexity of the economy, there is no way to achieve complete certainty on the inflation rate, but it can still be estimated by similar metrics.
Function
Compare any investment to the inflation rate. It is always better to save money into a safe account or security that is appreciating regularly relative to just keeping it in cash or in a checking account, but even so, it’s not a guarantee that the money will actually appreciate in real terms relative to the cost of living. In periods of low inflation, those that save their money are greatly benefited. In periods of high inflation, however, savers are penalized, because the money loses value faster than it appreciates in the accounts.
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Features
The lowest risk investments are savings accounts, money market accounts, U.S. government bonds, certificates of deposit, and select highly rated corporate bonds. Bond funds are also low-risk investments relative to funds made up of stocks and other higher-risk securities like options contracts. Investing in these securities requires less research than attempting to profit from more volatile securities trading, so in that sense, it requires less preparation to invest.
Considerations
Government bonds–most notably municipal government bonds–have high tax advantages. For example, the yields of municipal bonds and any capital gains from their sales are not subject to any taxes at all, making them potentially a superior low-risk investment choice relative to savings accounts and other low-interest but highly secure financial options. Federal bonds have several miscellaneous tax advantages. Consult a tax preparation professional.
Benefits
Low-risk investments are most often used to shore up an investment portfolio, to make sure that at least the principal of the investments will be protected in the case of a broad-based market downturn. Those with unstable careers or unpredictable income may find that having a portfolio exclusively composed of low-risk investments may be their best choice. Investment strategies like bonds and certificates of deposit ladders can increase overall rates of return while maintaining a similarly low level of overall risk.
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