There Is No Such Thing as a Risk-Free Asset

Risk taking does not come naturally to most people. For every inveterate risk taker, there are a handful of individuals happy to stay as far away from risk as possible. For the rest of us, risk taking is much more of a learned response. In fact, there is evidence of a large genetic component in our willingness to take on financial risk.

This mismatch between our innate desire to take risk and our need to take risk to generate returns represents the lifeblood of the financial industry. Much of what the financial industry does is to create vehicles that mitigate risk. At its worst, the industry tries to fudge or hide the risk of certain investments altogether.

Sometimes society as a whole decides it is in our collective interest to mitigate risk. One of the most visible instances is FDIC insurance. Bank deposits for individuals are now guaranteed up to $250,000 per bank. The government does this so that individuals are not at risk to the failure of a bank, in addition to trying to prevent bank runs. The FDIC is proud to note, “Since the FDIC began operation in 1934, no depositor has ever lost a penny of FDIC-insured deposits.”

 That guarantee, however, is not absolute. In the midst of the financial crisis, the limit was increased to what it is now. There is nothing that prevents, however difficult politically, a future government from reducing the limit.

The point is that in the above case, government — and in other cases, the financial services industry — acts in a way to try and entice risk-averse investors to take on investment risk. A perfectly reasonable way of doing this is through collective vehicles such as mutual funds and, more recently, exchange-traded funds (ETFs). To a person, investors recognize that investing in a portfolio of stocks is less risky than investing in any individual or handful of stocks. By mitigating the risk of an individual stock, the hope is that a fund investor is able to enjoy a general rise in stock prices over time.

For most this is a welcome development because the stock market is a cruel place. The high-profile Dow Jones Industrial Average recently celebrated its 115th anniversary. It might surprise you that only one company, GE, has been in the index from the outset.

 Clearly permanence is not a feature of the equity markets. We need

 not look out over an entire century to see equity risk; we need only look a year or two in advance.

In 2001 Enron Corporation went bankrupt.

 It is not news that companies go bankrupt. Companies large and small go bankrupt all the time. What is news was that Enron had been one of the largest companies in market capitalization in the United States and had been named for six years running as “most innovative” among Fortune's Most Admired Companies. This stunning turn of events is a lesson in the risks of any individual company, even one as widely held and admired as Enron.

Market participants recognize that equities, individually and as a whole, are risky. Academics can debate the precise types and amounts of risk, but suffice it to say that few today believe that equities are risk free in any sense of the term. The picture when it comes to fixed income is very different. Risk in the fixed-income market is a different beast altogether.

In the bond markets, investors are worried about two things: “When am I supposed to get paid back?” and “Am I going to get paid back in full, and if not, how much will I receive?” Everything else really stems from these two questions. The bond market, compared with the equity market, is therefore more up front in its approach to risk taking (and risk avoidance).

Despite its many flaws and its woeful performance in light of the financial crisis, the rating agency paradigm is still the way in which the bond markets stratify risk. At the very bottom of the risk scale are bonds issued by the U.S. Treasury. These securities are assumed by most market participants to be risk free, despite recent political turmoil that threatened the U.S. Treasury's ability to manage the debt. Every other bond is subsequently priced in reference to Treasuries.

If the fixed-income story ended there, it would be a straightforward one. On average, lower-rated bonds default more often than higher-rated bonds, and fixed-income investors on average price bonds accordingly. So when a company as big and as high profile as General Motors declares bankruptcy, it does not come as that great a shock to the markets.

Other times investors can be caught flat-footed. One could argue that the onset of the financial crisis was caused by the rapid decline

 in Lehman Brothers' liquidity position and its subsequent bankruptcy. Among the investors caught unaware were many money market mutual funds that were ill equipped to deal with securities that faced a permanent markdown in value. Funds that were supposed to be risk free were shown to be anything but.

This shock was a primary reason why the global financial system essentially locked up overnight. One could argue that the financial crisis was an ongoing series of miscalculations on the part of issuers and investors. Issuers created securities, nominally rated as risk free by the ratings agencies, that came along with higher coupons. Investors were more than happy to purchase these securities in the hope of garnering additional yield.

This highly stylized view of the financial crisis of 2007–2009 just happens to confirm the proposition made earlier that a primary role of the financial markets is to coax risk-averse investors into risky securities. Sometimes bankers and their clients fool themselves into thinking that financial alchemy is possible, that somehow we can turn risky securities into risk-free ones. While diversification can mitigate some risks, it cannot eliminate them. If we learn one lesson, it is that risk is inherent in the financial markets. We can try to identify and reduce those risks through careful portfolio construction, but those risks still remain.

Nor should we ever believe that any security is truly risk free.

 Even Treasuries that are assumed to be risk free are not. Let's leave aside interest rate risk for the moment. While there is little risk that those securities will not be paid off in whole, there is a range of outcomes that make Treasuries risky. For foreign investors, a continued decline in the U.S. dollar would make U.S. government securities a money-losing proposition.

For domestic investors, currently much of the Treasury yield curve is trading below expected inflation. Investors are therefore likely to experience negative real, after inflation, returns. We are also leaving the issue of taxes aside at the moment. This is not an unusual situation for the past couple of years. In fact, talk of “financial repression” is rearing its head. This would be a policy of keeping interest rates low for a long time, which would make the available real return on Treasuries in any foreseeable scenario negative.

So if securities that are assumed by everyone to be risk free actually entail real risks, we should recognize that every investment entails risk. The great challenge for investors is to accurately identify these inherent risks before they come to pass. Unfortunately our minds ensure that we will get fooled from time to time. Extrapolating past returns into the future is a common mistake that investors make time and time again.

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