Hedging Your Bets
Investing wisely during uncertain economic times can protect your nest egg.
By Marsha Bertrand

Investing for your future can be daunting even in good economic times, but add the complications of low interest rates, a volatile stock market, and an uncertain economy, and the task becomes even more intimidating. In this type of environment, many investors start looking for safer investments. Safer investments pay lower returns, but a lower return and safe principal is better than losing your principal altogether. Below are a few investments that may help you sleep at night until the stock market exits the roller coaster.

CDs, treasuries, and money market funds

Most investors are familiar with certificates of deposit (CDs), treasuries, and money market funds, which are some of the safest investments you can make. Unfortunately, they also pay next to nothing. That brings us to the dilemma of how to define the term "safe investment."

"If your definition of safe is that your principal is protected and the money will always be there, then those instruments are safe," says Brian Fricke, a certified financial planner in Maitland, Fla. "If, on the other hand, your definition of safe is never outliving your money, then these investments tend to be very risky, because historically they have not kept up with inflation."

If your goal is to protect your principal, remember that according to the theory of risk vs. reward, the higher the risk of an investment, the higher the reward. Therefore, when looking for an investment that offers safety, investors cannot expect to get 1990s stock market returns. If safety means keeping your principal intact, then CDs, treasuries, and money market funds may be a good short-term investment for you. If you're trying to keep ahead of inflation, these investments may work during some periods and not others.

Corporate and government bonds

Buying highly rated bonds gives investors the opportunity to lock in a specific interest rate and be ensured they'll get their principal back when the bond matures. The key is to buy bonds that are rated a, aa, or aaa by Moody's or Standard & Poor's rating agencies. aaa rated bonds are the highest quality bonds you can buy. It's best to buy bonds that have short maturities so you can move your money to higher-interest-rate bonds as rates move up. The value of the bond will fluctuate as interest rates move up and down, but as long as you hold the bond to maturity, it doesn't make any difference. At maturity, you can purchase a new bond - hopefully, at a higher rate. You may, however, want to buy bonds only with new money - not money that's already in equities.

"Don't commit double suicide," advises Fricke. "If you sell your stocks at an all-time low and buy bonds, you're buying bonds when interest rates are at a 30-year to 40-year low and prices are high. When interest rates rise, the value of the bonds will drop and you'll end up with two investments that went down in value while you held them."

Convertible bonds

A convertible bond is offered by a business that wants to borrow money in the marketplace. The bond pays a fixed rate of interest and has an option to convert to corporate common stock when the stock hits a certain price, which is called the conversion price. The conversion price is set above the price of the company's stock on the day the bonds are issued. When the company's stock price hits the conversion price, the convertible bond can be exchanged for a specified number of shares of stock.

"Because convertible bonds are subject to interest rate risk and sector risk, it's better to buy them in a fund," says Carol Wilson, certified financial planner and president of Wilson Financial Advisors Inc. in Salt Lake City. "Overall, they're a good way to participate in equities without taking the whole risk, because you're receiving the interest payments until they convert. Typically, the fund will sell the bond when it converts to a stock and buy a new convertible bond."

Real estate investment trusts (REITs)

A REIT is an investment vehicle that combines investors' funds, just like a mutual fund, except that a REIT invests those funds in real estate purchases. That real estate may be hotels, apartment buildings, shopping centers, or other large commercial parcels. The REIT earns income from the operation of the properties and, eventually, from selling the properties - ideally for a profit.

"I would go with a REIT mutual fund," says Wilson. "Look for one with a good track record and a good manager. The manager can pick which part of the economy is going to be good and buy into that sector."

If you choose to purchase an individual REIT, be sure to look at the underlying properties the REIT owns to be sure they are in geographic areas and real estate sectors that will do well. Also look at the financing. Make sure the underlying assets are owned with little or no debt.

How much of your portfolio should be in real estate? As with most investment questions, that depends on whom you ask. Wilson suggests only about 10 percent, while Fricke advocates having at least 20 percent of a portfolio in real estate. You should find your own comfort level, weigh the pros and cons, and determine your own level of real estate investment.

International mutual funds

U.S.-based companies account for approximately one-third of the world's stock market. Therefore, if you don't include stocks of other countries in your portfolio, you're missing out on two-thirds of the world's market. Adding an international component to your portfolio can help reduce risk because the stocks of companies in other countries often move in different directions than the U.S. markets. While they're still stocks of public companies, they may be a safer bet while the U.S. economy is in the doldrums. But do your homework, and be sure you're buying a good fund with a good manager.

"I'd buy a core international fund that invests in at least three different continents with an emphasis in Europe," stresses Wilson. "You can have a little Asia and a little South America, but Europe is best right now. The euro is firming up, and every time the euro gains on the dollar, that gives appreciation to American investors in international funds."

Reading the fine print

In times of a depressed stock market and low interest rates, finding safer investments is important. In doing that, it's sometimes difficult not to be drawn to investments that claim to be safe, yet pay high returns. Below are a couple of investments that are often touted as safe. Be sure to read the small print in the company's literature before you hand over your money.

Annuities: An annuity is a contract between you and an insurance company. You purchase the annuity, and then, typically at retirement, it pays you income. If you buy an annuity, make sure you understand what rate you'll receive for the life of the annuity and what withdrawal penalties apply.

"We see annuities offering 7 percent, but if you read the fine print, that rate is guaranteed only for a year," says Fricke. "If you want to get out of the annuity, there are severe withdrawal penalties for five or 10 years, and when it's time to renew the interest rate, the annuity company can renew it at below-market rates to compensate themselves for the attractive first-year rate."

Viatical Settlements: A viatical settlement is an investment in which an investor buys, at a discount, the life insurance policy of a terminally ill person. The investor becomes the beneficiary and collects on the policy when the person dies.

"This industry is rife with problems as far as the estimated life expectancies are concerned," says Fricke. "It's not a well-regulated industry, and there have been a lot of scams."

Many viatical settlements will purport returns of as much as 12 percent. That should put up a red flag and make any investor question their legitimacy.

The good news is that a depressed stock market won't stay depressed forever. Many financial advisors say there are great bargains in the stock market right now. The problem is investors don't know which stocks will turn out to be the bargains, or where the bottom of the market is. While you're trying to figure all of that out, at least you have a few places where you can park your money and keep it safe.