Thursday, September 16, 2010

The Next Step After Frugality: Preserving Capital With Low-Risk Investment Vehicles

At the outset of the Subprime Mortage Crisis during 2008, I had a fascinating conversation with two successful business professionals.  Both were their early 50’s. One was a partner in a large Real Estate investment firm in Chicago, and the second was a Physician who owned his own medical practice.  During the course of our conversation, both of them communicated to me that if they had invested all of their net worth in T-Bills for their entire professional careers, both would have been able to retire early.  I was shocked!  They had each experienced such massive losses in the market throughout their career, and then oftentimes got out at the worst of times, that they would have been much better off if they had simply invested in low-interest, but extremely safe, T-Bills.
This exact story is why many investors are currently adjusting their portfolios by adopting a lower risk investor profile.  Preservation of capital is the number one priority for many investors in the current economic climate of uncertainty that is present in most developed nations around the world.  As rumors of a possible double dip recession surface in various news publications, the one thing people one more than anything is to not lose money.
Savings Accounts
Savings Accounts offer the smallest rate of return in comparison to other low-risk investments.  While they are the most liquid, they also have the weakest return.  Furthermore, when the Federal Reserve lowers interest rates in the United States due to economic recession, the rate of return on a Savings Account will likewise fall.  This very low rate of return, sometimes even below 1%, is why many investors do not like to keep funds in a Savings Account for very long.  However, if liquidity and preservation of capital is your goal, a Savings Account is an excellent place to park funds.  Also, they are considered extremely safe because if a bank were to fail, the FDIC insures against loss.
Money Market Accounts
Money Market Accounts are similar to a Savings Account.  Investors deposit funds in a Money Market Account at their banking institution, but they are offered a return that is slightly higher than a savings account.  The risk on the investors side is still very low, but they are subject to different terms concerning the minimum amount deposited and how often they can deposit and withdraw funds.  For this reason, Money Market Accounts are seen as less liquid than a standard savings account, but they do offer a higher rate of interest.  This investment vehicle is great for an investor who knows that the investment funds will not be needed for a longer period of time.
Certificates of Deposit
Certificates of Deposit (CD’s) are a favorite amongst investors seeking to preserve capital with a low risk investment vehicle.  While CD’s are also issued by banking institutions, they offer a higher interest rate than a standard Savings Account of Money Market Account.  They are the highest returning investment vehicle that the FDIC still insures against loss.  The downside to CD’s is they are much less liquid.  In fact, depending on the CD, funds generally cannot be withdrawn for several months up to several years.  Funds withdrawn before the maturity date are hit with various fees.
Bonds are issued as debt by a company.  Thus, when you purchase a corporate or sovereign bond, you are essentially loaning that company or country money.  For this reason, bonds are seen as a relatively safe investment.  Bonds do, however, vary in their risk profile.  Bonds are generally rated with a letter sequence, such as AAA, that signifies how risky they are.  A bond issued by a company such as Microsoft is regarded as extremely safe, with little to no chance of default.  An investor can take more risk in search of greater reward and invest in junk bonds.  These bonds will return a higher rate of interest, but the risk of default is also much higher.
T-Bills are seen as the safest form of investment for very large players in the financial world.  When investors want to protect their capital, but still want to get a small return on their investment, they will oftentimes purchase Treasury Bills.  Treasury Bills are debt issued by the U.S. Government.  When an investor purchases a T-Bill, he or she is essentially loaning the U.S. Government money.   This investment vehicle is seen as extremely safe, since the probability of the U.S. Government defaulting on its debt is extremely low.  T-Bills will also typically return less than a bond, since the risk is less.  In currency trading, when there is a large amount of T-Bills being purchased during times of economic uncertainty, the U.S. Dollar will often rise in value due to this great demand for U.S. safety.

The are serveral types of low risk investment vehicles, but it is up to you to decide which one is best for you. Always preform a 3rd party check before commiting to an investment broker, and take the time to do a little research. Part of preserving your hard earned money for
retirement is making sure inflation doesn't eat away at it slowly underneath your matress.

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