Now that we’ve spent a good 5000 words introducing you to riskier investments like stocks, it’s time to spend some words on the safer alternatives. Bonds, Cash, or CDs represent the safer side of investments. These investments, have lower volatility than stocks. IE. they are less likely to lose 50% of their value overnight, unlike stocks. But they are also less likely to gain 50% in any given year. The real value of these investments is when combined with stocks they reduce your potential loss in case you need the funds at some point.
For example, imagine I have 2 portfolios, One is 50% stocks and 50% bonds. The other is 100% stocks. The stock market drops 50% while the bonds only drop 20%. This is a real scenario similar to 2018. Anyway, the portfolio that is 100% stocks is now worth half. The mixed portfolio, however, is still worth 65% of the original value. That extra 15% value might be the difference between you losing it and pulling the plug. Or worse it might be the difference between not being able to pay your bills.
The other aspect bonds bring, which is only true sometimes, is their returns are not always correlated. So sometimes when stocks decline bonds don’t. That brings the potential that the 65% preserved holdings are even higher. You can read about why to buy bonds here: Why Should I Invest in Bonds?
But Which Low Volatility Investments Should You Purchase?
There are many types of bonds and near bond investments. Which to buy? We have already established that cash is a poor investment choice due to inflation?. So what is the right choice for your safer investments? Well, you have a few options.
Individual Bonds as a Safer Investment
An individual bond is typically sold by a company or government to raise funds. In the case of a bond you are essentially acting as a lender. The bonds are bought and sold through an online market. Bonds typically pay you back for holding them through what is known as a coupon, or interest paid periodically over the life of the bond. (although there are some that sell with 0 coupons) Your original investment amount plus or minus any discount or premium meanwhile is typically returned to you either at maturity or when you decide to sell the bond to someone else. Maturity being defined as the date in which the bond is scheduled to pay back it’s original face value.
Buying and selling individual bonds is a tricky business and not something I’d recommend to the new investor. From understanding call features to which bonds are protected by FDIC insurance. The process can be confusing. Add to that individual bonds sell infrequently. This infrequent sales history can mean prices you pay and receive differ from underlying value since demand is low. It also means you don’t ever want to buy an individual bond unless you plan to hold it to maturity. The resell misplacing can eat you alive. You can read more about how to invest in individual bonds here, but I don’t recommend a novice use them.
Bond Funds as a Safer Investment
If you truly want to invest in bonds then the best choice is a bond fund. A bond fund solves the issue of demand price discrepancy. Large bond funds have the connections and set up to buy bonds without the price discrepancy. Furthermore, bond funds fit our principle of investing, diversification. If you buy a bond fund you get a collection of a bunch of bonds. So you are not overly exposed to the risks of inflation, pricing discrepancies, or counterparts risk of any single issue.
Now a note, bond funds like stock funds behave the same way as their underlying bonds. So inflation and other issues still impact them in the same way. If bond returns go up in the market, the price of an existing holding goes down. If bond returns go down in the market, then prices decline. You can read more about how bonds react to inflation here: Declining Bond Price Impact at Maturity Versus Sold Today. Your return on a bond fund goes the same direction as the aggregate price of all bonds in the fund. You can read more about bond funds and how to invest in them here: How do Bond Funds Work?.
A note, most total market bond funds focus on bond issuers that are less likely to default. This means they are unlikely to contain a significant amount of truly risky bonds. Just like stocks the riskier the bonds the higher the coupon rate you are likely to receive. That being said newer investors should not be buying higher risk bonds, called junk bonds. After all, the whole point of the bond portfolio for a newer investor is to dampen market volatility. Junk bonds meanwhile tend to behave roughly equivalent to stocks, ie. they are high risk.
CDs as a Safer Investment
CDs, otherwise known as certificates of deposit, meanwhile, are instruments sold by banks as investment vehicles. There are actually two types of CDs.
The first are those you buy directly from a bank. These CDs typically can be purchased for a period of months to 10 years. The benefit of these vehicles is often they have options where you can get your funds back with only a minor penalty of a few month’s interest. The obvious benefit here being built-in inflation protection from larger inflation moves. I really like these investments, although the downside is you can usually only buy them directly from a bank. This means they can’t be kept in a tax-advantaged account.
The second option is brokerage CDs. These are still sold by banks but typically through a market action at a stock brokerage. For example, Fidelity or Schwab might sell you a brokerage CD. These CDs perform almost exactly like bonds. The only way to cash them out early is to sell them to someone else., like Bonds. The only real difference between bonds and brokerage CDs is that the CDs typically have FDIC insurance. IE. the federal government guarantees most CDs against the counterparty risk of the issuer going bankrupt. This protection does not mean you cannot lose money by selling price discrepancy or inflation. Like individual bonds, I don’t recommend directly purchasing brokerage CDs due to pricing discrepancies.
If you can tell from above I favor using bank CDs when they are available at decent rates. You can read more about their benefits here: The Benefits of a CD Ladder for Safe Investments. In general, their lack of counterparty risk, inflationary protection, and generally higher returns make buying cds purchased directly from a bank a viable safer investment.
One potential way to structure a CD investment is what is called a CD ladder. The idea is you can further reduce inflation risk by buying CDs in such a way that they mature a little bit at a time over the course of years. In this way you can continue to reinvest them at different times, potentially receiving a more diversified long term return.
Savings Bonds as a Safer Investment
The final safe investment you’ll likely hear about is savings bonds. I’ve noted before I actually wrote my thesis on savings bonds versus another type of bond called Tips. In essence, there are 2 types of savings bonds.
EE Savings Bonds
The first is EE savings bonds. These return a fixed rate over their life. They also have a special feature wherein if you hold them 20 years they double in value regardless of return. That can be a good thing as calculated out that equates to a 3.5% return on an extremely low-risk investment. As of this writing, there are no other safer investments returning anywhere near 3.5%.
The problem, and why you should think long and hard about whether you buy EE bonds, is you only get that if you hold them 20 years. Holding them short even a month would mean just receiving the face value return, which is (again as of this writing) an abysmal rate of just .1%. Only cash has a worse return. So if you ever do buy an EE bond you better be sure you don’t need the money. You would also be taking on a significant risk of losing money if interest rates were to climb above 3.5%. The penalty to change course would be reallocate money at a higher rate would be steep.
The other savings bond option is an I-bond. These bonds essentially return a combination of inflation and a fixed return. The fixed return has lately been pretty minuscule. So the main focus of this bond is to keep up with inflation. It does so better than any other instrument on the market. The other inflation-protected set of bonds, known as TIPs, perform nowhere near as well in the majority of potential inflation environments. How much better? Well, the fed limits how many I-Bonds you can purchase a year to just $10K. There is no such annual limit on TIPs.
The problem with I bonds is since that fixed-rate kicker on more recent bonds is so small you are likely only keeping up with inflation plus a small nominal return. If you happen to hold older I-bonds with a decent fixed rate return that has not matured, then you definitely should keep them invested. You can read about what to do with older found paper savings bonds here: How to Manage Paper Savings Bonds. Otherwise, the question of whether you should invest in I-bonds really depends on your goals.
I-bonds are fairly liquid allowing sale after the first year for a minor interest penalty. So if you are looking for a near term or mid-term purchase they might be a good fit. But because of their purchase limits of $10K, the fact that they can only be purchased and held via the US treasury website, and new ones will not return anything significant over inflation I can’t recommend them to most users. After all one of the goals is to keep things simple by limiting your number of accounts.
No, if you are looking for a longer-term investment I believe you would be better off with a bank-purchased CD. You get the same inflation protection as an I bond via the CDs redemption policy, but you likely receive a higher overall return. Also, you can use the same institution where you keep your checking/savings account.
Dividends as Safer Investments?
A note on dividends. There is a belief out there that you can buy stocks that provide dividends and it will be just as safe as a bond. This is hogwash. The reality is a dividend paying stock is still a stock representing a company. The dividend is paid out of the same valuation metrics we referenced under stocks.
So if a company’s value declines because of a slowdown in the business cycle, then their profits have also likely declined. Which means they also have less money to pay their dividends. They have a choice, reduce their payments or sell assets to pay the dividend. One results in you not getting paid at all, unlike a bond. The second results in a decrease in the value of the underlying stock. In essence, you lost money either way. You can read more about it here: Dividends are not a Replacement for Bonds
If you do need to keep cash for a short term investment need or just your emergency fund, then you should make sure that cash returns as much as possible. To that end, any short term savings should go to an online savings accounts. Your local bank is likely returning .2% or less in interest. An online savings bank is likely producing 10x the returns. You can find a good source for great savings account rates here.
Can You Time Bond Purchases?
The final question I always seem to receive when discussing safe investments is can you time the bond market? This usually comes with some reference to how we are now at record low-interest rates and inflation, so how could it go lower? It’s basically an excuse not to hold bonds. There are some significant flaws with this argument though. The first thing to understand is interest rates are determined based on expectations of future inflation. Basically that expectation drives supply and demand that ultimately determines the rate. A change in that expectation will change the interest rate up or down.
Currently, Bonds Have a Potential Larger Capital Gain
It’s possible for interest rates to continued to go down, or even in the case of some countries go negative. Expectations change and there is no limit on which direction. We also know when interest rates decline existing bond prices go up, see above on how pricing of bonds work. The amount of this up and down in price is determined by the duration of the bond, a measure of how much a bond price will rise or fall as a percent based on a 1% change in market interest rates.
The thing is that duration is determined based on the length of the bond and the amount of its coupons (or fixed payments). The smaller the coupon the higher the duration. Put another way, suppose you bought a bond that only returns 2% interest in an annual coupon. That bond would have a longer duration than a bond with a 5% annual coupon. So with a 1% reduction in market interest rates, the price of the 2% coupon bond would increase in price faster than the 5% coupon bond…
Finally we know that we only realize that price gain if we sell the bond, otherwise, we are just awarded higher returns than other options (in essence the same thing but psychologically different). Bond funds sell bonds early all the time. So we know that with today’s low interest (and thus coupon) environment, bond funds actually have potentially larger than the normal return from bond price appreciation. At least in some ways, today’s bonds have even more potential upside then normal (and downside of course). You can read more about the historical movement of bond prices and what it all means here: Say No to Market Timing Bonds: History of Interest Rates
Common Questions about Safer Investments and Stocks
Before we leave the world of stocks and bonds for good, let’s talk about common questions about investing. The most common question I hear on a regular basis is what to do with a windfall of money. I’ve actually written 2 posts on this:
What to do with a Financial Windfall – In this post we talk about specifics like when to reallocate a windfall versus keep it in kind. Also, we talk about what might be a life-changing windfall. This windfall related to older I-Bonds.
What to do with a Surprise Windfall? – In this post we talk about the general options for a windfall of surprise money. Should you spend it or invest it? This windfall is more related to work bonuses and contractor employment income.
The other common question I hear is whether the stock market is rigged. Do insiders capture all the gains? Do some people have a leg up over others in investing. You can read the answers to these questions and how insider trading is avoided here: How Insider Trading Affects Us All
But What About Purchasing Real Estate?
We have now talked about stocks and bonds. But what about real estate?
Well, it depends on what you mean by real estate. As someone just starting out, buying a single real estate property for rent does not meet our diversification principle. All your eggs are in the one basket of the property which probably represents the majority of your assets. It does, however, meet the main determinate of making money on real estate, that the money is generally not made in the appreciation of property.
Say What? Yes the value of land or real estate itself has been showed to grow not much more than the rate of inflation. This inherently makes sense since real estate is a big piece of inflation measurements and most peoples day to day expenditures. But how does this fit? After all many big names have made their fortunes with real estate. Surely it is a good investment.
Well, it is.. But only when you account for both the appreciation of the real estate and the usage of the property while you own it. Ie the way to make money off real estate is to make money off a renter, run a business on the land, or use it for something like farming/logging. Then you have both the money from your business and the appreciation.
This leads to one simple conclusion. Real estate is not a passive investment but an active business in most forms. You shouldn’t buy real estate (or raw land) if you have no plans for a business or lack the desire to own one. There is nothing wrong with that but you need to go in with your eyes open.
Crowd Funded or Syndicated Real Estate
Now there is one glaring exception to this. That is the relatively recent concept of crowd-funded real estate. This makes it easier to do what was available forever in a private syndicate of investors. The general concept is you buy a small piece of a property with investors. Someone else runs the underlying business and you collect a portion of the profits. The benefit here also being that portion could be reality small allowing you to diversify across several properties. I have written about this concept a bit here: My Real Estate Investing Plan.
The problem here, of course, is the investment is only as strong as the underlying company running the business for you. Shortly after the post above one of the big players in the crowdfunding market threw in the towel on their business. They promised they would take care of existing investors as things wound down. However, I have to tell you I’ve been reading things from disgruntled investors of that market place ever since. So I guess my message here is to be careful who you decide to use as the sponsor or middle man of your real estate syndication.
One more thing about real estate. You don’t have to choose between investing in a retirement account and investing in real estate. You can invest in real estate from a retirement account. Here is more information how if interested: Self Direct IRAs and Real Estate Investments. I will note it can be complicated enough you probably want a CPA involved if you pursue this.
Now with all the above said I do want to make clear I am not an experienced real estate investor. I cannot advise you in-depth on what investments are good or bad beyond the general principles. For more in-depth information on real estate investing I tend to go to an expert. One great site for just such real estate knowledge is Coach Carson.
A note, if all of this seems a bit overwhelming, you might be better served by viewing a course introducing you to investing. I can strongly recommend Robert Schiller’s “Financial Markets” course, available on Coursera or Open Yale. These are not affiliate links, I get no remuneration from recommending this course, I am just that big a fan.
In addition, I can recommend the Benjamin Graham book “The Intelligent Investor” if you prefer your topics in book form. A note this book may be a bit closer to the moderate depth side, so I would recommend you start with some of the posts or courses also listed here.
Thanks for reading and I hope this is useful information on safer investing options. We will have one more post in this series next week on the value of money.