Investors with more than a five-year time horizon should think carefully before deciding they do not want any assets invested in the stock market. For these investors, a "safe" portfolio can actually be quite risky. The historical inflation rate is 3%. The low interest currently paid on money market funds (and similar investments) is taxed at ordinary income rates. The combination of inflation and taxes ensures a loss. This is not a good long-term investment strategy.

If you fit into the category of investors with a long-term time horizon, you can afford to take more risk, in anticipation of receiving greater returns. You have to do so intelligently, by not taking more risk than is appropriate for you.

YOU WANT TO PRESERVE YOUR MONEY

Brokers often tell clients that certain investments are "as good as cash." Some are. Most are not. I am going to list your options in order of safety.

1. Cash

Many people talk about taking cash and "putting it in a mattress." Few do it. If you want to be as certain as possible that your cash will be there, you should store it in a safe deposit box at a reputable bank.

There is nothing illegal about storing cash in a safe deposit box. Doing so does not change your tax liability. All income, wherever held, must be reported to the IRS.

Cash stored in a safe deposit box is not FDIC insured.

You will need to check the rental agreement with the bank to determine if there is any prohibition against storing cash in its safe deposit boxes. The agreement may limit the liability of the bank in the event the cash is missing from the box. Banks typically do not insure against losses for theft or negligence, but they may still have liability depending upon the facts of a particular case.

The value of the cash you store is eroded every day by the ravages of inflation.

For this reason, even cash does not offer perfect safety, but at least you know that something tangible will be there for you.

2. Treasuries

U.S. Treasury securities are certificates issued by the U.S. government. They are backed by the full faith and credit of the U.S. government. Interest earned on treasury securities is exempt from state and local taxes, but not from federal income taxes.

Individuals can purchase treasuries online directly from the U.S. Treasury.

When considering treasuries, keep in mind that those with long durations (over five years) are subject to the possibility of meaningful price fluctuation when interest rates change. Many experts believe that investors would be well advised to limit purchases to treasuries with durations ranging from one to five years.

Treasury bills are short-term securities. The longest duration is one year. They are sold at a discount from face value.

Treasury notes have longer durations of two, five and ten years. Interest is paid every six months.

Treasury bonds have a 30-year term. Interest is paid every six months.

Treasury Inflation-Protected Securities (TIPS) adjust for inflation. When inflation increases, the principal of the TIPS increase as well. When inflation decreases, the principal decreases.

TIPS pay interest at a fixed rate on the adjusted principal every six months. When TIPS mature, you get the greater of the principal as adjusted for inflation, or the original principal, whichever is greater.

I-Savings Bonds are sold at face value. A maximum of $5,000 can be purchased in any one year.

The accrued interest on these bonds is paid when you redeem them. You must hold them for a minimum of one year. If you redeem them before five years, you forfeit the most recent three months' interest.

The earnings rate of I-bonds is a combination of a fixed rate and an inflation adjusted rate.

Unlike TIPS, I-bonds cannot be bought or sold in the secondary market.

EE/E Savings Bonds

Electronic EE savings bonds are sold at face value and paper EE bonds are sold at half of face value. They earn a fixed rate of return. They are also subject to a maximum purchase limit of $5,000 per year.

They increase in value every month. Interest is compounded semi-annually. They must be held for a minimum of one year, but if you redeem them in the first five years, you'll forfeit the three most recent months' interest.

Because of the safety of treasuries and the current demand for them, the interest rates are very low. A one-year treasury bill is currently paying only 1.31%.

3. Bank savings accounts

Bank savings accounts are exactly what they seem. You deposit money in an account at a bank. The bank pays you interest. You can withdraw your money at any time. Some banks place restrictions on the number of free withdrawals, so be sure to check with your bank to be sure you understand any limitations or requirements for a minimum balance.

You should be sure your bank is insured by the FDIC. You can do so by calling 1-877-275-3342, or by going here. The newly revised FDIC insurance coverage is $250,000 per depositor, per insured bank.

FDIC insurance is backed by the full faith and credit of the U.S. government.

Because the risk of loss in these accounts is extremely low, the interest paid on these accounts is also minimal.

The annual percentage yield currently for these accounts is around 2.4%. If you are comfortable with an online account, you may be able to obtain slightly higher rates with an online bank. If you agree to maintain a higher minimum balance, this may also improve your interest rate.

Be sure your bank is FDIC insured.

4. Bank CDs

The good news about Bank CDs is you can achieve a higher rate of interest. The bad news is they are not liquid. You will have to commit to tying up your funds for a given period of time or risk a penalty.

The typical bank CD is for a stated period. At the end of the term, the bank promises to return your principal, plus a fixed amount of interest. Interest is often paid during the term of the CD, rather than all upon redemption.

Common CD terms range between 90 days and five years.

You will want to be sure your CD is FDIC insured.

One year CDs are currently paying an average interest rate of 3.64%.

5. Money Market Mutual Funds

A money market mutual fund invests in short-term debt (bond) obligations. The goal is to preserve capital, but money market funds do pay interest.

Money market funds do not all have the same degree of safety.

The highest level of safety can be found in a money market fund that limits its investments to treasuries, since treasuries are backed by the full faith and credit of the U.S. government.

The Vanguard Treasury Money Market Fund (VMPXX) is one example. Because the risk of loss is so low, the interest rate is comparatively low as well. This fund is currently paying only 1.48%.

One step up the risk ladder are money market funds that invest in securities issued by government agencies. These securities are not backed by the full faith and credit of the U.S. government, and the risk of loss, while still small, is greater than treasury money market funds. Many investors believe that the government would step in to prevent the default by a government agency of its bond obligations, and recent events indicate there is reason to believe it would. However, it is not legally obligated to do so.

The Vanguard Federal Money Market Fund (VMFXX) is one example of this kind of fund. It is currently paying 2.07% interest.

A modestly more risky money market fund is one that invests in high-quality, short-term securities, like Certificates of Deposit and Commercial Paper, usually in addition to government and agency debt. Clearly, this mix is more subject to loss than the portfolios of the less risky funds. Investors in these funds are rewarded with modestly higher returns.

The Vanguard Prime Money Market Fund (VMMXX) is an example of this kind of fund. It is paying 2.31% interest.

While these are the most common types of money market funds, there are also tax-exempt money market funds that are exempt from federal income taxes, and state specific tax exempt funds that are exempt from both state and federal income taxes if you are a resident of that state.

Money market funds are not guaranteed by the FDIC. However, due to unprecedented market conditions, the U.S. Treasury Department recently enacted a temporary guaranty program for amounts held in participating funds on the close of business on September 19, 2008. Further information about this program is available here.

Investors seeking the safety of money market funds would be well advised to consider those offered by major fund families like Vanguard, Fidelity and Charles Schwab.

6. Bond Funds

A bond fund is a mutual fund that invests in bonds. These funds have varying degrees of risk, depending on the safety and stability of the underlying bonds.

The performance of bond funds is usually measured against a benchmark called the Lehman Bros. Aggregate Bond Index. This is an index made up primarily of investment grade bonds, treasury securities and mortgage-backed securities.

There is strong academic evidence that bond markets are as efficient as the stock markets. There are a number of exchange-traded funds (ETFs) and index funds that have very low expenses and do an excellent job of tracking the Lehman Bros. Aggregate Bond Index.

The iShares Lehman Aggregate Bond ETF (NYSE: AGG) is an excellent choice.

The Vanguard Total Bond Market Index Fund (VBMFX) is a good option for those seeking an index fund.

Many bond fund managers believe that they can beat the index. The major player in this area is PIMCO. You can find a study it authored on this subject here.

Actively managed bond funds charge over 300% more for their funds than ETFs and index funds. I believe investors would be better served by the less expensive index funds that always capture the returns of the benchmark, less low costs.

YOU CAN AFFORD MARKET RISK

Most investors can afford to take some degree of market risk. The trade-off is the likelihood of superior long-term returns. Here are the best options. They nicely balance risk and reward.

As the present market climate illustrates, the stock market can be volatile -- in both directions. That is why it is so important to have a time horizon long enough so that you can wait out the kind of bear market we are experiencing now.

There may be a better way to deal with the inevitability of inflation and taxes, but I don't know what it is!

1. Balanced or Target Retirement Funds

A so-called balanced fund is one that combines a portion of stocks, bonds and short-term investments in one portfolio. These funds typically maintain that mix all the time (they don't try to time the market), and are designed with average investors in mind.

I like Target Retirement Funds (also called Lifecycle Funds).

These funds invest in cash, stocks and bonds. The percentage allocated to each depends on the year of the fund you select. You should choose the year in the fund name nearest to your expected retirement date.

The fund automatically changes its asset allocation to become more conservative as it nears its end date.

The primary benefit of these funds is that they do all the work for you. No need to put together a portfolio from a confusing selection of mutual funds and to change your asset allocation as you age. The Target Retirement Fund does all this automatically. Just set it and forget it.

If you are considering a Target Retirement Fund, look for one where the underlying funds are all index funds, with low expense ratios. Vanguard's Retirement Funds meet these high standards. You can learn more about them here.

Target Retirement Funds are not for everyone. You need to be sure the asset allocation is appropriate for you. Just because two people are going to retire in the same year does not necessarily mean the same asset allocation is right for both of them. You might be able to tolerate more risk, or need a more conservative asset allocation.

Those investors should consider one of the three index fund portfolios I discuss next.

2. Conservative Risk Mix of Index Funds

This portfolio is for investors who have a minimum of five years before they will need 20% or more of their investments.

It is a conservative portfolio, with low volatility. Only 20% of your portfolio will be in stocks. The balance will be in bonds.

Your entire portfolio will consist of low-cost index funds. I use Vanguard as an example of a fund family with excellent, very low cost index funds. Fidelity and T. Rowe Price also have similar funds.

Let's assume you have $10,000 to invest. Here is how your conservative portfolio would look:

1. Put 70% of the amount allocated to stocks (70% of $2,000=$1,400) in the Vanguard Total Stock Market Index Fund (VTSMX);

2. Put 30% of the amount allocated to stocks (30% of $2,000=$600) in the Vanguard Total International Stock Index Fund (VGTSX);

3. Put 100% of the amount allocated to bonds (100% of $8,000=$8,000) in the Vanguard Total Bond Index Fund (VBMFX).

4. Rebalance your portfolio once or twice a year to keep your asset allocation intact or change it if your objectives or tolerance for risk have changed.

The historical annualized returns for this portfolio are in the 9% range. Historical data is not predictive of future returns. This simple portfolio beat the returns of over 90% of professionally managed funds over the long term.

If you are a conservative investor, this portfolio is worthy of consideration.

3. Moderate Risk Mix of Index Funds

This portfolio is for investors who have a minimum of seven years before they will need 20% or more of their investments.

It is a moderate risk portfolio, with moderate volatility. 60% of your portfolio will be in stocks. The balance will be in bonds.

Let's assume you have $10,000 to invest. Here is how your moderate risk portfolio would look:

1. Put 70% of the amount allocated to stocks (70% of $6,000=$4,200) in the Vanguard Total Stock Market Index Fund (VTSMX);

2. Put 30% of the amount allocated to stocks (30% of $6,000=$1,800) in the Vanguard Total International Stock Index Fund (VGTSX);

3. Put 100% of the amount allocated to bonds (100% of $4,000=$4,000) in the Vanguard Total Bond Index Fund (VBMFX).

4. Rebalance your portfolio once or twice a year to keep your asset allocation intact or change it if your objectives or tolerance for risk have changed.

The historical annualized returns for this portfolio are in the 10% range. Historical data is not predictive of future returns. This simple portfolio beat the returns of over 90% of professionally managed funds over the long term.

If you can tolerate moderate risk, this portfolio is worthy of consideration.

4. Aggressive Risk Mix of Index Funds

This portfolio is for investors who have a minimum of 12 years before they will need 20% or more of their investments.

It is an aggressive risk portfolio, with high volatility. 100% of your portfolio will be in stocks.

Let's assume you have $10,000 to invest. Here is how your aggressive risk portfolio would look:

1. Put 70% (70% of $10,000=$7,000) in the Vanguard Total Stock Market Index Fund (VTSMX);

2. Put 30% (30% of $10,000=$3,000) in the Vanguard Total International Stock Index Fund (VGTSX);

3. Rebalance your portfolio once or twice a year to keep your asset allocation intact or change it if your objectives or tolerance for risk have changed.

The historical annualized returns for this portfolio are in the 11%-12% range. Historical data is not predictive of future returns. This simple portfolio beat the returns of over 90% of professionally managed funds over the long term.

If you can tolerate high risk and volatility, it is worthy of consideration.

A final thought about current market conditions: Professional investors understand that, with risk, comes reward. Investors who stay the course and don't panic have historically been rewarded for their perseverance. With every bear market the pundits say that it is different this time. This has never been true. It is unlikely that is now.


See a summary of Daniel Solin's 10 investment options here.