Risk-free. Right now you are likely sighing contentedly, thinking about the freedom this idea offers. In investing terms, risk-free means that you won’t lose money, that your profit is guaranteed, that you don’t have to stress.
Risk-Free Investing – Treasury Bills
Unfortunately, risk-free investing is a commonly misapplied term. This is because there is more than one way to understand the word “risk.”
When most of us think of risk-free, we think of safety. For example, a U.S. Treasury bill (T-bill) is widely viewed as the definitive risk-free, or safe, asset. What happens with T-bills, essentially, is that the American government is borrowing your money, which it later returns to you, with interest.
T-bills feel safe because it is hard to imagine the American government not having enough money to pay you back. After all, when they get low on cash, they can always print more or raise taxes. The U.S. dollar is the world’s reserve currency (for now, at least, and for the foreseeable future), so there’s little concern there.
T-bills also offer a feeling of security because of their place in stock analyst calculations. The T-bill interest rate for three months is called the “risk-free rate.” This number is then used to determine the growth rate for a given company and the value of a given stock.
Besides T-bills, other types of bonds are often also considered a “safe” or low-risk investment. Let’s consider what low-risk means in this context.
Risk-Free Investing – Default Risk
Unlike other investments like real estate, stocks, or commodities, bonds only carry two main risks. One is default risk – if the company, or government, can’t give you back what they borrowed, or not make their interest payments.
The other is inflation risk – you get your original investment back, but by then the value of what your dollar can buy has dropped because prices have gone up.
As for a government defaulting, this risk is fairly low. Statistically, countries seldom default on their loans. But the situation is not as risk-free as we may think. Who of us is not familiar with the recent debt woes of Greece or Argentina?
And they are not alone. Historically, over the years, many nations have faced similar situations. Just because an investment has low risk does not necessarily mean that it is 100 percent safe.
Actually, just a few countries can happily report a totally clean default record – among them the United States, Singapore, Malaysia, England, and Canada.
America has been on the verge of defaulting however, and its credit rating suffered as a result. Before 2011, the rating was AAA – the top level, a very safe place to be. But it was demoted to AA+, robbing the U.S. of its risk-free distinction. The potential risk of default did affect the feeling of safety for this country.
Risk-Free Investing – Inflation
Let’s talk about the effect of inflation. Inflation affects us in a very real way in day-to-day life. We’ve all had the depressing experience of going into the store with the weekly grocery budget money in our pocket and coming out with one bag fewer than usual, cursing inflation all the way home. That money just couldn’t buy as much as it did one week earlier. It would be nice if it went the other way once in a while.
In investment terms, factoring in inflation gives you the “real rate of return”. A positive real return rate is when an investment earns you more than inflation takes away. So you can go home with an armload full of groceries, and money in your pocket.
A negative rate results in those missing groceries – inflation has eaten up some of your earnings. So all your money is spent, and your shelves are a little emptier than they should be.
The risk lies in the fact that no one can accurately predict the inflation rate. Will it be less than the interest you earn, the same, or more? Depending on inflation, your T-bill, or any other bond you own, stands to gain or lose money. If inflation is too high, you could “lose” more than you gain by owning a T-bill or bond that doesn’t pay much interest.
So, although T-bills are considered risk-free, investing in them at this point would not get you any further ahead.
The “risk-free” label may bring a false sense of security, even when it comes to T-bills. Understanding the real risks involved, such as the possibility of default and the effect of inflation, is a much more practical way to evaluate any investment decision.
Kim Iskyan is the founder of Truewealth Publishing, an independent investment research company based in Singapore. Click here to sign up to receive the Truewealth Asian Investment Daily in the your in box every day, for free.
Kim has nearly 25 years of experience as a stock analyst, hedge fund manager, political risk consultant, and financial commentator in more than half a dozen emerging and frontier markets.
He’s been quoted in the Economist, The New York Times, the Wall Street Journal, Barron’s, and Bloomberg, and has appeared on Fox Business News, China Central Television, and Bloomberg TV, and has written commentary for the Wall Street Journal, Slate.com, Salon, TheStreet.com, breakingviews.com, and other publications.
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