When Risk Free...Really Isn't

In the hallowed halls of theoretical finance, one of the pillars of modern portfolio theory is the concept of the risk-free rate of return. Like unicorns, leprechauns, mermaids, and other things that inhabit the world of make believe, of course no such creature truly exits.

Case in point: U.S. Treasury Bills are presumed to be the best proxy for risk-free return. But is that really the case? At the most basic level, the risk-free rate of return is presumed to be a positive rate of return derived from any default proof security. While we could all quibble about whether or not the U.S. government is actually a default proof credit, let’s for a moment accept that it is. In the construct of this artificially manufactured default free presumption, what risk-free return actually gets you is liquidity, stability of principal, and not much else. It certainly does not get you stable and predictable income, and depending on the purchased basket of goods and services that comprise the arc of your lifestyle, it probably doesn’t go nearly far enough to preserve your purchasing power against the corrosive effects of inflation

For the vast majority of investors who require responsible long-term rates of return to meet personal financial planning objectives, the real problem with the whole idea of a risk-free rate of return is how it subtly corrupts rational thought about long-term financial planning by promoting a “risk on – risk off” trading mentality. React a little quicker than the slow-footed institutional behemoths or better yet, just avoid the last 10% of a bear market and you’re in tall cotton. How hard can it possibly be? Can’t do it yourself? Hire the right advisor and he/she ought to be able to deftly sidestep the worst market selloffs…right?

Like the sweet song of the sirens in Greek mythology, this approach is little more than an invitation to disaster. Increasing the frequency of asset allocation decisions in an investment portfolio not only fails to mitigate investment risk, it actually serves to elevate the very risk it seeks to avoid. Guaranteed.

Michael Reid, CFA is a Managing Director and Partner at Exchange Capital Management. The opinions expressed in this article are his own.