Investing

Growing Your Investment Portfolio Safely

General Motors HeadquartersIf there is one thing that we have learned over the last several years, it is that there is no such thing – almost – as a guaranteed investment. While the Dow Jones Industrial Average may be up over 22% since the beginning of 2013, we have just come out of a number of years of unprecedented volatility, with major banking stocks and even such perennial blue-chip favorites as General Motors going to the wall. Obviously, the goal of most investors is to maximize the value of their portfolio, but there is no upside in taking excessive risks. Investors need to be sure that they have a sustainable investment model, and that they are not overly vulnerable to short-term market fluctuations.

One key element of this is portfolio diversification. In general, when a portfolio spans a large number of industry sectors and types of investment, it is less likely to experience severe drops. A simple example of this is stocks and bonds, which tend to run contrary to each other when it comes to returns. A canny investor will vary their mix of stocks and bonds in order to maximize their return, but they will make sure that they keep both in their portfolio in order to mitigate risk. Similarly, some industries run contrary to each other, therefore investing broadly tends to mitigate risk – when one is coming down, another one is going up.

nest eggAnother key strategy for portfolio stability is investing a portion of available capital in diversified instruments such as index funds. These are funds which are directly linked to stock market indices such as the DJIA, tracking the index value exactly. Although you track, rather than beat, the market, you are likely to see reasonable returns over time, so long as you wait. Since index funds are diversified by definition, they are less susceptible to wild short-term price fluctuations. Of course, there will still be short-term blips, but the overall trajectory will be upward over a period of decades.

For investors who want to leverage stock market rises while keeping their risk levels to an absolute minimum, CDs are another potential option. While this may seem surprising – for instance, the 10-year CD may be the worst bank product ever – some types of CDs offer effective risk-adjusted returns. For instance, indexed CDs are linked to indices in the same way that index funds are, but the initial investment is completely safe – and insured by the FDIC up to $250,000. Investors get a percentage of the increase in the index – the participation rate – but do not lose money if the index falls. For example, if the index rises 10% in a year and the participation rate is 75%, then the investor receives a 7.5% return on their initial outlay. However, there are some caveats around this – participation rates vary widely, and in some cases there is no guarantee that an investor will receive their full initial principal back if they terminate the CD early.

Image Sources: GM Headquarters and Golden Eggs

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Grayson Bell

Grayson Bell

I'm a business owner, blogger, father, and husband. I used credit cards too much and found myself in over $50,000 in debt. I paid it off, started this blog, and my financial life has changed. I now talk about fighting debt and growing wealth here. I run a blog management company, along with another blog. It is Empowered Shopper, which helps people get information about products they want to buy. You can also check out Eyes on the Dollar, which is a great blog that I co-own.

10 Comments

  1. November 20, 2013 at 7:38 am — Reply

    I wasn’t aware of the CDs with risk-adjusted returns. That is an interesting concept. So if the index falls the investor does not lose money- but does that mean they get 0% return at those times? Thanks for the info.

  2. November 20, 2013 at 8:11 am — Reply

    Diversification cannot be stressed enough. Any given company or industry can take a beating, but if you diversify by investing in index funds as you suggested you should be able to mitigate that risk. I like to keep some of my 401k (a relatively small portion) in emerging market funds to get some further diversification.

  3. November 20, 2013 at 9:31 am — Reply

    There is no free lunch and products like the CD described will come with a cost, either in terms of limited returns or in actually dollar amounts. No one is going to give you the upside and take the downside. In most cases it’s better to simply create a balanced portfolio between stocks, bonds and cash than to try and use these kinds of hybrid products.

  4. November 20, 2013 at 12:36 pm — Reply

    I think the indexed CDs can be a good option, assuming it’s right for the investor and your initial investment is guaranteed. That said, there are so few products out there today for those wanting to get some sort of return without taking on a ton of risk. If we listen to what is coming out of Washington, it’ll continue to stay that way for the foreseeable future.

  5. November 20, 2013 at 12:39 pm — Reply

    It’s tough to squeeze a dime out of the banks in Canada where we live, they’re conservative as heck compared to U.S. counterparts. (Maybe that’s why none required a taxpayer bailout in 2008-09.) I’ve looked at the sort of product you reference, but, like Matt says, the bank is willing to share some of the upside potential but none of the downside risk. I passed on the product.

  6. November 20, 2013 at 4:53 pm — Reply

    When I was at my bank a few years back, they tried to sell me on their market linked CDs. It sounded like a good deal, but it was a little complex. Like Matt said, there is no free lunch. I did some research into it back then, and it just wasn’t something I wanted to get into. I prefer to stick to simple, easy to understand investments. If you do invest in those market linked CDs, make sure to read the prospectus closely. It might be a good investment vehicle for someone who doesn’t want to get into the stock market…but willing to do so with a market linked CD.

  7. November 20, 2013 at 9:24 pm — Reply

    Nice write up Grayson. Index funds are where we started and have gone on to other investing instruments/funds from there. For the beginner, I think that’s the best and safest option.

  8. November 21, 2013 at 1:13 pm — Reply

    There is a very good write-up of indexed CDs on the Bogleheads wiki. Note their warning, “Market-Linked CDs are complicated investments which are not recommended for new investors. They are a type of structured product, but without the risk of losing principal. Please ask in the forum for advice.”

  9. Fehmeen
    November 21, 2013 at 2:58 pm — Reply

    It’s never wise to invest all of one’s money in the stock market because everyone knows it takes no longer than a few days for the market to crash and the value of your assets to tumble down. Diversification is a concept that cannot be stressed enough, and I personally am in favor of less risky investments (such as savings accounts, or stocks that continue to pay dividends even when the market is down).

  10. Richard Jonas @ PrivateQuote.com
    November 21, 2013 at 2:58 pm — Reply

    Thanks Grayson,

    As always, you gave us solid, actionable advice. I’d just like to add an additional option for your readers to consider. It’s a life insurance product called Indexed Universal Life. It offers financial flexibility, growth potential and downside protection, college savings, retirement income, as well as significant income tax advantages. Please Google it.

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