If 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.
Another 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.