Building a low-risk portfolio

The ideal way of building a low-risk portfolio will depend on many factors, including time-frame for the portfolio. Below, you will find a few examples of securities frequently included in low-risk portfolios. Please note that low-risk isn’t the same as no-risk. All investments come with risk – even low-risk investments.

In addition to picking low-risk investments, an investor can seek to decrease risk by carefully balancing the investment portfolio. Diversification is a commonly utilized method for mitigating and managing investment risk. Putting together a portfolio of low-risk securities where all securities are exposed to exactly the same risk can make the portfolio riskier. For instance, government bonds are considered low-risk, but if your entire portfolio consists of bonds issued by the same government you are in a way putting all your eggs in the same – albeit low-risk – basket.

If we look at historical date, we can see an inverse correlation between diversified U.S. equities and diversified U.S. treasury bonds. This implies that a carefully selected portfolio containing both U.S.equities such as blue chip stocks and U.S. treasury bonds can be a good option for an investor seeking low risk. In order to diversify even more, the investor can chose to include non-US equities and bonds as well, to achieve a greater geographical diversification. Also, an investor may opt to include more asset classes, e.g. real estate and commodities.

For the more savvy investor, risk can be mitigated using derivatives.

Governmental Bonds

A bond is a type of debt security. Governmental bonds are bonds issued by a national government and backed by that country. Some governments and countries have a higher credit rating than others. For instance, a bond issued by the U.S. government is typically considered much lower risk than a bond issued by the Mozambique government. The three main credit rating agencies for sovereign bond issuers are Standard & Poor’s, Fitch and Moody’s.

A governmental bond will usually (but not always) work like this:

  1. The bond is issued and sold.
  2. The issuer is contractually bound to make periodic interest payments to the holder of the bond, throughout the lifetime of the bond.
  3. When the bond expires on the maturity date, the issuer is contractually bound to pay the holder of the bond the face value of the bond.

When you make a risk assessment of your low-risk portfolio, remember that bonds can be issued in the currency of the issuing country. If the currency is subjected to significant inflation, the face value of the bond may translate into very low purchasing power on the maturity date. Some countries issue inflation-indexed bonds to make their bonds more appealing to investors. For such a bond, the face value follows a consumer price index or similar.

USA: Treasury Inflation Protected Securities (TIPS)

Treasury Inflation Protected Securities (TIPS) are treasury securities backed by the U.S. government and considered extremely low risk. TIPS are indexed to inflation; the par value rises with inflation (as measured by the Consumer Price Index). The interest rate is fixed and is paid semiannually. TIPS usually pay a lower interest than other government securities. TIPS are available with 5-year maturity, 10-year maturity and 30-year maturity.

TIPS are suitable even for investors with small bankrolls. The minimum investment required is no more then 100 USD when you purchase TIPS directly from the U.S. government through the TreasuryDirect system.

Important: When the par value is increased, this is considered a taxable income by the IRS in the United States – even though there might be 25+ years left until maturity. To avoid this tax, some investors prefer to purchase shares in a TIPS mutual fund instead of owning TIPS in their own name. There are also exchange-traded funds (ETFs) available that invest in TIPS. Another option is to hold your TIPS in a tax-deferred retirement account.

Municipal Bonds

Municipal bonds are issued by a municipality, such as a city. The risk rating of the bond will dependon on the credit rating of the municipality. Generally speaking, municipal bonds tend to be considered higher risk than government bonds, but there are of course large variations within the category.

USA

In the United States, municipal bonds are exempt from state and federal taxation, and some also receive favorable tax treatment at the local level. Municipal bonds are issued by a lot of different entities, e.g cities and school districts. There is a big and highly liquid market for trade-able bonds from U.S. municipalities.

Low-Risk Bank Products

Most consumer banks offer low-risk bank products. There are for instance bank accounts where you receive a favorable interest in exchange for not making any withdrawals during a certain number of months or years. Always check if the account is covered by national bank insurance before you make any deposit, otherwise you risk losing your money if the bank files for bankruptcy. In the United States, the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration insure many bank accounts, up to a certain limit.