Lesson 4: How safe are your investments?

How safe are your investments?

November 26th, 2011 by

safety basicsThe concept that the higher the risk of investment, the higher the return investors are going to require is a relatively simple one.  What is a little more complicated, and what we will examine here, is how to determine what is risky and what is not.

The least risky investments are ones that come with a guarantee from the US Government against loss.  This comes in 2 forms:

1. FDIC Insured Accounts

Banking products such as savings accounts and Certificates of Deposits, which are are insured by the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Association (NCUA), are guaranteed against loss up to $250,000.  You can learn more about FDIC and NCUA Insurance here.

US Government Debt

US Government bonds (including savings bonds and Treasuries) are backed by the full faith and credit of the US government. The guarantee of the US government is considered extremely solid, as the government has the power to print currency and levy taxes on the largest economy of the world. If you buy a US government bond, you can lose money if you sell it prior to maturity. The government does not guarantee the market price, but the interest payments and repayment of principal.

Varying Levels of Protection Against Loss

Insurance

With the exception of variable annuities, annuities are protected against loss of principal by the insurance company that issued the annuity.  In this case the quality of the loss guarantee depends on the viability of the insurer. You can find information on how insurance companies are rated from the A.M.Best Company at ambest.com.

Corporate Guarantee

The principal and interest payments on corporate debt are “guaranteed” by the corporation in the sense that as long as they do not file for bankruptcy or restructure bondholders are paid.  When investing in a company’s stock there is zero guarantee that you will not lose money. This is why investing in the bonds of a company is generally considered safer than investing in the company’s stock.

The stronger a corporation’s financials and the more stable its underlying business, the less likely something will happen that will interfere with its ability to pay bondholders. Rating agencies are paid to evaluate how sure you can be that a company will not default (pay you interest and principal) on your bonds.   While information from rating agencies can be helpful, their ratings are often wrong. As recently as 2008, they gave many bonds which ended up defaulting, their highest safety rating. After the first couple defaults, they downgraded similar bonds. In other words, their ratings tend to be reactive rather than pro-active.  With this in mind you should do your own research in addition to looking at a bond’s rating.  You can learn more about the ratings agencies here.

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