No Such Thing As A Risk-Free Rate
In financial theory the "risk free rate" is usually proxied as the yield on government bonds. Since the US government is able to print its own currency, it will not ever need to default on its own debt which is denominated in US dollars.
Short of world going dark, you will get your principal and interest back.
Riskless? Not quite. If the total dollars you get back buy less than they used to in terms of goods and services you have lost wealth in real terms.
Bad News First: Risk Is Unavoidable
Investing firm Newfound Research has a mantra:
Risk cannot be destroyed, but only transformed.
This is clear when you consider the trade-off you must always face —the possibility of "failing slow" or "failing fast".
When you are young, you risk "failing slow":
The primary risk of investors with growth mandates (e.g. investors early in their lifecycle) is “failing slow,” which is the failure to grow their capital sufficiently to outpace inflation or meet future liabilities. In this case, our aim should be to diversify as much as possible without overly de-risking the portfolio.
As you approach retirement, you risk "failing fast":
For investors taking withdrawals (e.g. those late in their lifecycle), the primary risk is “failing fast” from large drawdowns. Diversification is likely insufficient on its own and de-risking may be prudent.
The Good News: Risk Offers The Possibility Of Reward
Newfound describes risk as "a blob that is spread across future states of the world. When we push down on that blob in one future state, in effect “reducing risk,” it simply displaces to another state."
Entrepreneurs and businesses incur risks that span from minuscule to extremely speculative. This provides investors like you a spectrum of opportunities to partner with them according to your own appetite. An appetite that balances how much return you require in balancing your tolerance for losing fast or losing slow.
Without the possibility of loss, you would not be afforded a chance to earn returns.
Newfound compares investors to the management of insurance companies:
In many ways, we can think of ourselves and our portfolios as insurance companies: we collect premiums for bearing risk...When we buy stocks, we are really trading a certain cashflow today (the price) for a stream of uncertain cash flows in the future. The discount between the price we pay and the net present value of future cash flows is the premium we expect to earn.
Author Morgan Housel offers a another useful frame — the distinction between a fine and a fee:
A fine means you did something wrong like, “Shame on you, here’s your speeding ticket. Don’t do it ever again, you’re in trouble.” And a fee is just a price of admission that you paid to get something better on the other side. Like you go to Disneyland, you pay the fee, and then you get to enjoy the theme park. You didn’t do anything wrong, it’s just that’s the fee.
If you see the volatility in investing as a fee instead of a fine, then it just becomes a little bit more palatable. And when the market falls 30 percent, it’s not that you enjoy it, you don’t think it’s fun, but you’re like, “Okay, I understand this is the fee that I have to be willing to pay in order to do well over a long period of time.” Most investors don’t do that. When their portfolio falls 30 percent, they say, “I fucked up. I did something wrong. I clearly made a mistake. And how can I make sure this never happens again?” And that’s the wrong way to think about it. And I think if you view it as a fee instead of a fine, it’s just much more realistic to deal with.
The huge majority of the pain that people go through and put themselves through is just the fee for earning superior returns over time. And if you’re not willing to pay that, then you’re probably not going to get the reward on the other side. And that’s why you can see so many people who at the first experience with being uncomfortable in investing with a loss, they view it as they screwed up and then they want out. They want to move on to something else. And of course, they’re not going to get the rewards over time.
Nothing in life is going to give you those rewards for free. There’s a cost to everything. And just identifying what the cost is then realizing that the cost is not on a price tag, you’re going to pay for it with stress and anxiety, and dopamine, and cortisol. That’s how you pay for these things.
The specter of risk and prospect of reward are 2 sides of the same coin
Learn More
- Newfound Research's No Pain, No Premium (Link)