As we have seen, the rates of return on low-risk securities are extremely low. In fact, they are structured in such a way so that they will never outpace inflation. What then happens when your appetite for higher returns grows, but you are not willing to risk losing your money?
There are many moderate-risk investment options that yield better rates of return for investors who would prefer not to lose their principal amounts. These investment options offer opportunities to earn higher rates of return than those of risk-free securities, such as treasury bills and CDs, while safeguarding the investor’s principal amount. These include:
1) Preferred Stock
A stock (share) means ownership or equity in a company. There are two types of stock: preferred and common stock. Preferred stock falls under this moderate risk category because, despite being equity, they are more like hybrid assets that lie between a bond and a stock.
These stocks have specified dividend rates that are normally 2% higher than those offered by treasuries and CDs, and these dividends are paid monthly or quarterly. They have low liquidity risk, since they can be sold at any time without penalties. The main risks associated with preferred stock are market and tax risks.
For security and insurance purposes, credit rating agencies grade and assess the default risk probabilities of most preferred stock, in the same manner as those done for bonds. A high rating of AA means that the issuer of the preferred stock has financial stability. A low-rated stock usually pays a higher return to compensate for its higher risk of default.
Types of Preferred Stock:
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Convertible Preferred Stock. This allows an investor to convert the stock to a fixed number of common stock.
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Participating Preferred Stock. This allows the investor to receive larger dividends when the company is financially doing well.
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Cumulative Preferred Stock. The investor’s dividends are accumulated and paid at a later date due to the company’s financially instability. Payments are made after the company has caught up with its obligations to pay out the dividends.
2) Income Fund
This is a mutual fund that aims to provide income for investors from the securities represented in that fund. Returns are generated from dividends and interest rates from these securities. In an income fund, share prices are not fixed and tend to decrease when the interest rates increase and increase when the interest rates are declining. Income funds are very safe and are for investors who do not mind their low share prices and, hence, lower rates of return.
Income funds include instruments such as mortgages, preferred stock, utility stocks, cash and bonds, among others, leaving an investor with a wide range of options on what to invest in. Diversification is ideal, where investors can invest in all the different types of instruments, which ensures that risk is minimized.
3) Exchange-Traded Funds (ETFs)
These are securities that are listed and traded on stock exchanges in the same manner as stocks. ETF, just like mutual funds, is comprised of assets such as commodities, bonds, cash (currency) and stocks. The main difference between ETF and mutual funds are that mutual funds are not listed on exchanges nor traded throughout the day.
4) Fixed Annuities
These are insurance contracts that offer a set and specific amount of income that is paid at a regular interval until a specific period has ended or event (such as death) has taken place. Fixed annuities are perfect for those about to retire as well as those who have retired already because they help stabilize their income. An investor can put in an unlimited amount of money before they retire or pass on.
Some annuities are indexed, which indicates that they can provide investors with a portion of returns in both the equity and debt markets while the principal is still guaranteed. Indexed means that they are listed on an exchange and hence traded on the stock market. If a security like this one is indexed, then it means that dividends (for stocks) or interest rates (for debts) are paid to the investor. Returns on investment can be profitable when the markets are performing well.
The main risks associated with with fixed annuities are interest rate risk and liquidity risk, especially when the investor is penalised for withdrawing their money.
Overall, fixed annuities are relatively safe and therefore offer lower rates of return compared to preferred stocks. Some fixed annuities, on the other hand, offer higher teaser rates, which are used as tools to entice and attract investors. These higher rates eventually decline in the longer run once targets have been met.