Tags: risk | free | return | mirage

The Mirage of ‘Risk-Free’ Returns

Wednesday, 30 Jan 2013 07:53 AM

By Patrick Watson

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Financial planners used to talk about a “risk-free rate of return.” I don’t hear this term much anymore — and now I think it may have been a mirage all along.

Much like a thirsty man in the desert, every investor wants return without risk. What a fantasy! Just throw in your cash and be absolutely sure it will grow by ___ percent every year. No worries.

What number goes in the blank? Good question. When I first entered the business, we would look to the three-month CD or Treasury interest rate. You could assume guaranteed 5 percent annual yields and no one blinked.

This assumption was, in turn, plugged into spreadsheet models to create asset-allocation strategies. It was the baseline against which everything was measured. Any “risk asset” had to make more than the risk-free rate — sometimes much more — to justify its presence in a portfolio.

Now, of course, we live in a world where short-term interest rates are practically zero. The risk-free rate is also practically zero. That, in turn, lowers the bar for risk assets. Investors, unable to make anything from cash, are more willing than ever to buy stocks, bonds, gold, real estate, commodities, you name it.

What all such “risk assets” have in common is this: You can lose your money in them. The likelihood of loss may be higher or lower — but it is always more than zero. Add inflation and taxes to the equation, and even bank deposits are break-even at best.

Since 2008, we’ve had a critical change, one that even some financial professionals haven’t fully grasped. There is no more risk-free rate of return! Now everything contains risk.

Investors obviously know this on some level, since they’re pouring cash into stocks and stock funds. I’m not sure how many understand what could happen to their money. They grew up in a world where it was possible to start with $10,000 and still have at least $10,000, no matter what.

That world no longer exists. Anyone who thinks they see it is probably hallucinating.

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