Does risk-free investing exist?

As with the mythical cup believed to have magical powers, many have searched in vain for the secret to risk-free investing, long considered the financial world’s "holy grail." Some claim to have found it or know what it looks like, but does it really exist?

In truth, the answer is no. There is no such thing as risk-free investing. All investments have some risk, even those that are generally considered to be among the safest on earth. This includes government-issued securities, most notably Treasury bills and bonds backed by the full faith and credit of the United States, which have traditionally been viewed as one of the best ways to invest risk-free.

Many risks to consider

But as the events of recent years have shown, there is always some risk associated with owning even supposedly risk-free investments. That doesn't necessarily mean, of course, that your capital will be wiped out. But politicians and central bankers can take–and have taken–actions that can undermine the value of government-issued securities in some way or another.

For one thing, they can spend or borrow more than is prudent, which can spur inflation that reduces the purchasing power of your money. They can also set borrowing costs–interest rates–that are artificially low, penalizing those who prefer to take as little risk as possible. In addition, they may introduce tax, retirement or other policy changes that leave holders of public sector obligations in a risky position.

Under the circumstances, rather than asking "What is risk-free investing? or "What are risk-free investments?" or "Where can I find risk-free investing online?" it makes more sense to understand the relationship between what you can earn on your money and what you might lose when it comes to any particular option.

Striking the right balance between risk and reward

Simply put, the greater the possibility that you will have a loss of capital–or, in the case of a bond, a shortfall in interest–the more that you will want as compensation. If you invest in a fixed-income security, for example, you would naturally prefer a higher interest rate (or initial discount rate) if the borrower has a poor credit history. If you finance a start-up, you would expect to pay less for your shares than if it was a blue-chip company.

This is one reason why bonds issued by shaky third-world countries typically offer significantly higher yields than those backed by developed nations. Since there is an increased likelihood you will lose your capital if you invest in the former, you will want the promise of more in return for your initial investment.

But the notion of risk doesn't just apply to any particular investment. While it would be great to think that you could avoid taking maximum risk by choosing very wisely, that is not always realistic or even possible. The better way to address the issue is from a broad perspective, by taking what is known about portfolio diversification.

The financial world's only "free lunch"

Sophisticated money managers and academic researchers have found that there is a lot to be gained from not having all your eggs in one basket. Diversification not only reduces the threat of getting badly hurt or even wiped out by any one holding, it can also help improve overall investment performance. In part, this reflects the fact that at any given time, different assets classes are marching to their own beat, helping to cancel out the daily, weekly and monthly ups and downs.

Regardless of why it works, research indicates that diversification reduces risk in portfolios and helps to enhance long-term performance. Portfolios that are exposed to a variety of securities or asset classes benefit from what experts have described as the financial world's only “free lunch.” In other words, even though investors keep betting on the strategy, which often means that it eventually stops working, it nonetheless continues to pay dividends year after year.

More broadly, investors who are serious about achieving long-term financial security need to ensure that they maintain the right sort of balance with respect to the quantity and quality of the investments they hold. Professionals managing trillions of dollars of pension fund and other assets figured out long ago that they needed to include more than just "plain vanilla" investments, such as stocks and bonds, in their portfolios to have any real chance of achieving longer-term performance targets.

P2P: An increasingly popular alternative

This is one reason why institutions and individuals alike have increasingly sought out alternative investments, including peer-to-peer, or P2P lending. While this relatively new and fast-growing asset class is not a risk-free investment, it does have a great deal going for it. For one thing, it has had a strong track record over time. Ninety percent of the investors at Bondora, for example, a pioneer in online P2P investing, have generated more than 10% returns since 2009.

Making matters better is that the loans are being issued to near-prime borrowers who have had a history of living up to their obligations in good times and bad. In fact, unlike some of the more traditional asset classes, which tend to be more directly affected by the actions of central bankers or the health of the economy, P2P lending has, so far at least, performed fairly well under a range of circumstances, including during recessions and macroeconomic disruptions.

Aided by innovative technologies and the power of the internet, the way that online P2P marketplaces function helps to tilt the balance between risk and reward further in favor of investors. Instead of lending to a small number of individuals who may or not be good credit risks, investors can invest in loans to a great many borrowers whose histories they know much about. In addition, careful underwriting helps ensure those who seeking funding are offered terms that take full account of all the risks involved.

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Sleep better at night

With this sort of transparency and the extra layer of diversification, the prospect of making a bad decision is that much less. Of course, as the traditional warning goes, past performance is no guarantee of future results. Nevertheless, when investors can make informed decisions, aided by experienced and knowledgeable professionals, it can reduce the "I want to sleep at night" uncertainty. In today’s financial world, that seems about as close as anyone can get to risk-free investing.