This section discusses ways to reduce the risk associated with the basic plan. In reducing risk we trade the potential for larger profits for increased security.
Decreasing risk is not a necessary part of Buy-Only Rebalancing if there is no intention of ever spending the money that's invested. Otherwise, all the funds would ideally be in low-risk investments by the time the money is needed. Decreasing risk over time can accomplish the transition away from riskier investments.
A fun reason to decrease risk might be "taking profits" after a risky investment has increased in value. For example, a selected stock might take off in a bull market, and you might notice that the ratios at reuters.com look pretty bad. It might be a good time to sell the shares while they're worth a lot, investing the cash somewhere relatively safe.
Another reason to decrease the risk might be to affect a transition away from the moderate risk of investments like AAA-grade corporate bond ETFs (e.g. LQD) and whole-market ETFs (e.g. IWV). An easy way to start the transition would be to begin investing dividends in lower-risk investments.
Besides risks like death, war, disability, and other life-changing events, the biggest risk to invested funds is an attack on the value of the funds. Inflation is rarely mentioned by financial advisors but often mentioned by Market Wizards who have accumulated wealth through trading.
There are great low-risk investments that are subject to the risk of inflation but should nevertheless be considered.
When bonds are discussed, an important point should be kept in mind: buying and selling bonds is risky business because of interest rate risk. If interest rates in general increase, your bond loses value on the open market. Avoiding the open market makes interest rate risk a moot issue. By holding bonds until maturity you avoid selling them in the open market. Of course, that means planning. You have to choose bonds with a maturity that fits your plans.
CDs don't always get great rates. (They're lousy now.) They sometimes do, though, and they're not very risky in the U.S. because even though they're issued by banks that can fail, they're insured by the federal government.
There is a limit to the amount that is protected by federal insurance, though. The limit is per bank, but remember that if two banks share an owner, they are considered the same bank by the F.D.I.C.
AAA-rated municipal bonds can be bought through a discount broker five at a time, for about $5000. Interest paid by municipalities is not federally taxable, so unless the funds are in an IRA, the tax savings make a big difference. Municipal bonds often have a very high taxable equivalent yield. Not all "muni bonds" are low risk, but a general obligation bond can be relatively safe, because the local government can tax its constituents in order to pay you back. Even a general obligation, AAA-rated muni bond is not as safe as a bond issued by the U.S. Government, though.
Unlike muni bonds, corporate bonds have taxable returns, but those returns are nominally higher. (They might not be higher after federal taxes.) As long as the company issuing the bond stays in business, making enough money to pay you, your investment is still safe, but there's no guarantee the company will continue to do well. A corporate bond that has been rated AAA is considered very likely to pay you back. Still, if the company surprises everyone by going bankrupt, you could lose your investment. Corporate bonds can be bought one at a time for $1000 each, so they're a bit more convenient than muni bonds.
If the value of the dollar goes down, though, none of the above investments will protect the real buying power of your funds. The ones below will.
The U.S. Government is a good place to lend your money if you want to make sure you get it back. They are so low risk that they don't have to pay very high interest rates, but they offer some investment choices with an inflation protection feature.
These investments protect not only your dollars but their ability to buy stuff, which is really the point.
Recently the Treasury Direct website has gotten a makeover, and I found it highly usable and convenient. There is one little thing: The security is unusual and a bit technical—You even have to look up codes in a little table on a card they send you. But it's probably worth it, even if that kind of thing bothers you.
TIPS are Treasury Inflation Protected Securities issued by the U.S. Government.
I-Series Savings Bonds are earning 0% right now (June 2009) and so aren't too glamorous, but at least they're guaranteed not to have a negative return, and they're inflation protected.
It is easy to invest small amounts in I-Series Savings Bonds.
Once you have your money in these investments, it's not safe (from alien invasions, etc.), but it's as safe as it gets.