What is a “risk-free” investment, anyway?
Have you ever heard someone say that an investment was “risk-free?” What does this mean?
The Capital Asset Pricing Model (CAPM) considers a Treasury bill to be risk-free. A T-bill is a short term investment in the U. S. Government, and since the government has never reneged on its debt, this investment is supposed to be risk free.
But is it really?
Ignoring the possibility of the government defaulting on its debts, a T-bill is STILL not risk free. Default risk is just one of many risks to consider with any investment. Here are some other risks to consider:
Inflation risk — the risk that the return on the investment is below inflation, and thus you are actually losing purchasing power.
Reinvestment risk — The risk that periodic cash flows (such as interest or dividend payments) will have to be reinvested at a lower rate than is currently available.
Market risk — the risk that the investment’s market value declines.
Currency risk — for foreign investments, the risk that changes in foreign exchange rates decrease your return.
Liquidity risk — the risk that the market is not liquid enough to allow you to cash out an investment.
This is just a quick summary, there are many other risks to consider as well. But, the point is that calling A T-Bill “risk-free” is really not accurate. It may be default risk-free, but it is not completely risk-free. In fact, there is no investment in anything that is risk-free. All investments require a balance between the various potential risks, but none are completely risk-free.
You might say this is just semantics, but I would disagree. I have met many people with their entire 401(k) invested in T-Bills. When asked why, they say “Because they are risk-free.” These people don’t realize that inflation risk is probably a bigger concern than default risk for their portfolio.
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Comments
Inflation risk is something I’m always frustrated with personal financial planning textbooks about. They’ll talk about the risk of inflation and real interest rates in one chapter, but in the next chapter they compare an investment decision against the risk-free rate without even mentioning inflation risk.
For example, one chapter had a cost comparison of buying a car versus leasing. In both cases, the “true” cost of purchasing was factored in by (in part) seeing what the downpayment (for purchasing) and the up-front fee (for leasing) for the car would have been worth had they instead been invested in a 3 year t-bill, with no mention at all of inflation risk.
On the bright side, the personal finance students that also have me for macroeconomics are always quick to point out the textbook missing the risk of inflation…
JTapp,
Inflation is a big one. It’s almost worse when it’s in the low single digits, because people don’t notice it, which makes them think it doesn’t exist.
At least with double digit inflation, it is more obvious, which makes it easier to remember to account for it.
One of my pet peeves regarding inflation is the tax code. It completely ignores inflation when calculating capital gains. If I own a stock for several years, and its nominal price doubles, but inflation causes prices to double in that same period, I have no gain, but I am taxed as if I had one. This is actually one good argument for having a lower rate on long term gains, but it would be better if they just indexed the gains for inflation.
This is a great post. A lot of financial professionals I know are worried about default risk but aren’t thinking about the trillions of dollars entering the economy.
Scary question: Given that a lot of banks are still leveraged 15:1 and lend long-term but borrow short-term, what will happen when inflation forces the fed to raise rates? What’s the duration of a typical bank’s assets? Five years? What kind of rate increase would it take for a bank’s assets to lose 6.7% of their value?
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The market is unlimited.
Thomas Adair
thom…@hotmail.com
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