Patch Blog: Maximizing Income in Relatively Risk-Free Investments

“My mom has been doing fine with the tax-free interest from California bonds, but her bond portfolio diminishes as bonds are called. Aside from more bonds, how can we maximize income in relatively risk-free investments? Some argue that bonds tie up money too long, but what are the alternatives if income needs to be kept up?”

Ron Rosen  (5-15-11) 

This is a common dilemma. It goes something like this, “Interest rates are incredibly low, even if I lock it in for five years or more. I know the stock market has snapped back but I’m still scared to death of it.” Add to that the guy who wants to talk to you about an annuity. Sound familiar? 

It’s a confusing landscape, agreed. It is complicated further by everyone’s unique circumstances. But something, I believe, very useful in this discussion is a common understanding of the word “risk.” You said you want to “maximize income in ‘relatively’ risk-free investments.”

Risk is a fascinating word. It is emotionally charged and means something different to everyone. While I can’t know what “risk” means to you I can tell you that everything we do with our money is subject to the follow six risks.

• Inflation:  The risk that money won’t buy as much in the future as it does today.  When thinking about inflation as an investment risk, ask “How much did I pay for the first gallon of gasoline I ever bought?”  My point is that you ignore inflation at your peril.  Investments that pay a fixed rate of return are highly susceptible to inflation risk.
• Taxation:  This is the risk that you will not be able to have the use of every dollar you earn from your labor and your investments.  Tax risk will also follow your assets to the next generation in one form or another.  Taxes should be avoided wherever it makes sense.  It is, however, an inevitable cost. 
• Interest Rates:  The risk with the double-edged sword.  Interest rates and bond prices move opposite of one another.  Higher interest rates are had at the expense of a bond’s price.  And visa versa.  Bonds and interest rates can be as volatile as any stock market. 
• Market Risk:  If I had to guess this is the risk you meant when you said, “relatively risk-free.”  Many of us have read and/or lived the cautionary tale of “playing the market.”  And we know it ends badly.  Markets are not something to be played.  They are to be embraced in a life long relationship.  The rewards come to those who participate thoughtfully and at the least cost.
• Specific Risk:  I call this the “all your eggs in one basket” risk.  It used to be found in owning too much stock of the company you work for.  Today it is more likely to be a portfolio over-invested in the US.  The point being that the risks specific to US stocks will have a needlessly outsized negative impact on that portfolio.  A more global mix would spread the risk.
• Longevity:  Many of us have had the experience at some point of having too much month at the end of the money.  Longevity is the risk of having too much life at the end of the money.  Our growing understanding of what it means to be healthy and the advances in medicine and research means that we are living longer than ever.  In other words, your investment time horizon is probably a lot longer than you imagine.

A prudently sustainable investment plan takes into account each of these six risks.

Have a finance question? Gary has got an answer!