There’s No Such Thing as a “Risk Free” Investment
I find it ironic when I read investment articles that state bank CDs or government treasuries are risk free. Yes, you'll get a return OF your money, but will you get a return ON your money in real dollars? Especially in today's low-interest rate environment. Isn't it somewhat ironic when you hear of “risk free” investments from individuals, people automatically think it's a scam. Yet, why would a risk free government investment be any different?
One of things I've learned over the years in owning a business is risk assessment. Everything in life has risk. The only known is you will die someday and you'll pay taxes.
Maybe panic attacks I've had in the past have helped me become better at risk assessment, and in the process, become a better investor.
In business planning it's critical to know the possible risks, determine the possibility of those risks, and eliminate (or if not possible minimize) them. Successful business owners do risk assessment on a daily basis. Otherwise, they are soon out of business. Some risks aren't in your face obvious, either. Just like the economist theory popularized by Milton Fredman, “there's no such thing as a free lunch“. In investing:
Every investment has risk. It might not be apparent what the risk might be.
Traditional textbook investment books list these possible risks when investing:
- Credit Risk
- Market Risk
- Liquidity Risk
- Operational Risk
In my opinion missing from this list is inflation, and opportunity risk.
This means the chance that the investment will default. Governments, such as the United States, have a fiat currency. They are also a reserve currency and have no risk to default. The debt limit debate was all theatrics.
The problem then isn't credit risk, but inflation risk (see below) with the government printing money. Businesses, on the other hand, can go bankrupt.
Market risk is the price which can vary from day to day, and depending upon when you sell your security, could lose principal.
Most investors think this risk only applies to stocks, but it can also apply to bonds. For example, if you own a bond and sell it before maturity, it is possible you can lose principal.
Liquidity RiskProsper for example is a great investment, but is very illiquid. If I needed the money, it could take months before I could liquidate notes. In addition, I could take a significant haircut (market risk) in the process.
This type of risk happens from the running of a business, and the most common risk when owning one. Operational risk in a business can be in many forms and varies from business to business. Related to investing this could cause a loss in principal or future gains from say a server failure.
This one is missing from traditional financial text books, and it is the one that's the most subversive. The way I define it is you can lose money in real terms. So if a bank CD earns 2% APR annually, yet the annual inflation rate is 3% — you've lost 1% of your money in real terms.
So while the credit risk is low for government issued treasury bonds, it does have inflation risk. Inflation is a man-made monetary policy. So the same government who issues those bonds has also the power to inflate its currency. This then renders the real yield to be negative.
This is another risk not commonly discussed when investing. This risk is could your money be working harder for you in another investment?
So while you might be satisfied with earning 3% in a CD that's “risk free”, would you be better of investing in a high yield bond that earns 8%, with a less than 5% risk of default to maturity? It's always important to get the best value for you money when you shop; why should it be any different with investing?
Asset allocation and investment diversification can also minimize this risk.
You summed it up pretty well. I would say the most forgotten about risk (as you mentioned) is inflationary. People often think there’s no risk to “parking money in cash” but they’re losing purchasing power. Nice article.
The risk should equal the reward. High risk equal high reward! I try to mix my risks in my investment portfolio to achieve a good return without losing everything.
I would slightly change your statement to say “the reward should equal the risk”. IMHO CDs and treasuries aren’t worth the reward for the risk. At least in terms of real dollars.
What I didn’t state in the post is the traditional way to decrease risk is via diversification.
To me, CD rates don’t really make sense in terms of:
Liquidity risk – doesn’t that depend upon the CD though? Ally Bank has only one month deduction if you pull out before maturity.
What a tough time to invest in fixed income right now eh? Options are:
Bad to awful.