When the market fluctuates, some investors get scared and want to eliminate risk from their portfolios. Risk-free assets provide a safe harbor against market volatility, but that safety comes at a cost. These investments tend to have low rates of return, which can reduce your ability to meet your financial goals. Learn what risk-free assets are, their pros and cons and if they belong in your portfolio.
A financial advisor could help you put a retirement plan together for your goals and needs.
What Are Risk-Free Assets?
A risk-free asset is an investment with a guaranteed future value and virtually no potential for loss. Debt issued by the U.S. government (bonds, notes and Treasurys) is one of the most well-known risk-free assets. While these assets are no longer backed by gold assets, they are backed by the “full faith and credit” of the United States.
Investors shift their portfolios into risk-free assets during periods of uncertainty. U.S. Treasury bills are generally regarded as the safest investment in the world, which is why domestic and foreign investors buy so many during a downturn.
Other risk-free assets include:
- Treasury Inflation-Protected Securities (TIPS)
- Checking accounts
- Savings accounts
- Money market accounts
- Certificates of deposit (CDs)
Annuities, municipal bonds and money market funds are low-risk investments that some investors purchases. They tend to offer higher rates of return than risk-free investments in exchange for slightly more risk. In most cases, they will retain their value, but it is not guaranteed like a risk-free asset is.
Pros and Cons of Risk-Free Assets
- Avoid losses in the market. When you invest in risk-free assets, your portfolio is no longer subject to losses in the value of stocks and other investments. This strategy can protect your nest egg from losing money in an economic downturn.
- Guaranteed returns. Risk-free assets generally provide guaranteed returns that you agree to when you invest. If there are changes in future rates of return, risk-free assets provide notice ahead of time.
- No risk of default. Investors buying risk-free assets are certain that their money will be there for them when they need to withdraw it. With stocks and other risk-on assets, there are no guarantees that the investment will be worth anything in the future.
- Difficult to time the market. When you pull your money out of the market, you not only have to decide when to sell but also when to buy. You may get one decision right, but it’s difficult to choose the best dates for both.
- Low rates of return. By eliminating risk, you also give up the potential for higher returns. Guaranteed investments tend to have some of the lowest rates of return of any investments.
- May require locking up money for an extended timeframe. Depending on which risk-free assets you invest in, your money may be stuck there for a while. For example, CDs, U.S. Treasuries, TIPS and others have penalties if you withdraw before their maturity dates.
- Inflation erodes buying power. While safety may be appealing in the short term, inflation will reduce the value of your risk-free assets over time. It is important to have assets that outpace inflation to maintain your purchasing power.
Should You Have Risk-Free Assets in Your Portfolio?
Many investors choose to have a portion of their portfolios in risk-free assets. These assets provide a hedge against market downturns and the ability to buy more shares in risk-on assets when prices are down.
It is also wise to keep your emergency fund money in risk-free assets. This money is there when you need it most to cover unexpected expenses. Because of this, earning a high rate of return is not a focus for your emergency fund assets.
Retirees often keep one-to-two years’ worth of expenses in risk-free assets. This provides a pool of money that they can tap into for monthly income during a market downturn. Doing so prevents retirees from selling assets at lower values to pay for their monthly expenses.
Risk-free assets provide a safe haven for investors during turbulent times. They offer guaranteed returns without the probability of loss. While these returns can be minimal, investors can rest easy knowing that their portfolio value is not declining. It can make sense to shift into risk-free investments in uncertain times, but they are not a wise choice for long-term investing because inflation will erode their value over time.
Tips for Reducing Risk in Your Portfolio
- Financial advisors can share numerous options with investors to reduce risk in their portfolios. These strategies are personalized to your unique goals, risk tolerance and timeframe. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- One of the most popular strategies for reducing risk is diversification. Having a broad array of investments allows investors to minimize loss and participate in gains in other market sectors. Our asset allocation calculator shares example portfolios based on your answers to a simple questionnaire.
Photo credits: ©iStock.com/fizkes, ©iStock.com/fizkes, ©iStock.com/oatawa