No Risk Investments

Many retail investors distrust the stock market. This distrust stems from over a decade of asset bubbles, stock market crashes, accounting scandals, Ponzi schemes and slow regulatory reforms. Retail investors often fear the financial system is stacked against them.

Faced with their distrust and fear of the stock market, many retail investors have looked to "no risk" investments like cash, savings accounts or certificates of deposit (CDs) insured by the FDIC. To be sure, these investments are an effective way to avoid the daily ups-and-downs of today's volatile stock market.

However, a good question for retail investors who have shunned the stock market in favor of "no risk" investments is whether they have simply traded one set of risks for another set of risks. Many of these investors would be shocked to discover the answer is "yes". Their "no risk" investments carry their own risks, including a high probability that they will fail to meet their owner's long-term financial goals.

Many retail investors choose to invest in "no risk" investments because they are afraid of losing money on their investments. Ironically, by investing in "safe" investments like cash, savings accounts and CDs, these retail investors are almost assured of losing purchasing power on their investments.

The problem with "no risk" investments is that their typical returns are less than the rate of inflation. Today's economic environment nicely illustrates this problem. In today's market, the average annual yield on money market accounts and savings accounts is a paltry 0.12%, and the average rate on a one-year CD is only slightly higher at 0.27%. In contrast, the U.S. consumer inflation rate for 2012 was 1.7%.

Thus, a retail investor who invested his money in an average money market or savings account would have lost 1.58% of his purchasing power during 2012, and would have lost 1.43% of his purchasing power by buying one-year CDs. If the initial investment was $10,000, this would have translated into losses of $158 or $143, respectively.

Thus, an important risk of "no risk" investments is losing purchasing power.

Saving enough for retirement is an important financial goal for many investors. To save the huge pot of money needed for a comfortable retirement, financial advisors often assume investors will earn an average return of 7% or 8% over their careers.

By choosing "no risk" investments for their retirement savings, retail investors are almost guaranteed to fall short of their financial goals for retirement. The returns on such investments are much lower than the 7% or 8% rate of return that are often assumed by financial advisors, and the shortfall will be compounded each year.

For example, if an investor invests $500 per month into his 401k plan over his 30-year career, and he selects a mix of stocks and bonds with an average return of 8% per year, he'd retire with a nest egg of $745,179. But if he chooses "no risk" investments with an average return of only 1% per year, his nest egg would grow to only $209,814. Clearly, his conservative strategy would hurt his retirement.

So, another important risk of "no risk" investments is not saving enough for retirement.

Another risk of "no risk" investments is running out of money during retirement.

Assume an investor retires with a $500,000 nest egg. By selecting "no risk" investments earning 1% per year, he can withdraw only $5,000 per year from his nest egg without dipping into principle. Even when combined with social security and a small pension, this investor would likely want to withdraw more than this $5,000 per year from his nest egg, which would decrease its principle each year. Eventually, the nest egg would be depleted, and he'd need to decrease his standard of living.

In contrast, if his $500,000 nest egg were invested in a mixture of stocks and bonds earning 7% per year, he could withdraw $35,000 per year without dipping into principle.

Thus, another risk of "no risk" investing is running out of money during retirement.