Risk Free Investments Do Not Exist

Posted February 14th, 2012 in Investing by Jeremy Waller

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With the turmoil in the markets we’ve seen over the past few years it makes sense that people are more interested than ever in low-risk investments. I’ve even heard people talking about putting their money in “risk free” investments until the economy recovers.

The problem is there’s no such thing as a risk free investment.

Risk free implies that there is absolutely no chance that the value of your investment could decline. To state it another way, in order for an investment to be risk free you would need a guaranty that the purchasing power of your money in the future will be greater than or equal to the purchasing power of your money today.

That simply doesn’t exist in the real world.

Traditionally Safe Investments

A lot of people that are afraid to put their money in the market tend to flock towards a spectrum of “safe” investments. This could be anything from cash under a mattress to money market deposit accounts to CDs to U.S. Treasuries.

People feel safe when they stash their money in these vehicles because they essentially have a beta of zero. (Beta is a measure of price volatility.) If you put $1,000 into a bank account today you can walk into the bank tomorrow or next week or next year and take $1,000 back out.

People also tend to trust these vehicles, because they are backed directly by the U.S. Government or are insured by a government program, à la the FDIC.

But all of this completely misses the point.

All the guarantees in the world can’t protect you from one of the biggest risks of all: Inflation.

The Inflationary Elephant In The Room

Inflation is one of the biggest risks to a conservative investor – especially one that prefers low yield investments like CDs or Treasuries.

What Is Inflationary Risk?

Inflationary risk is:

The uncertainty over the future purchasing power of your investment

Put simply, it is the chance that your money will be worth less in the future than it is today.

In reality, chance doesn’t factor into it. It is practically certain that the purchasing power of your money will decline year after year.

Consumer Price Inflation 1900 - 2012

Over the last 47 years, the value of one dollar has declined 86%. It now takes $7 to buy what $1 would buy in the 1965. If you stashed $10,000 under the mattress in the mid 1960’s – it would have the same purchasing power as $1,500 today.

Not exactly a good investment.

On the other hand, if you put that same $10,000 in a S&P 500 index fund over the same time period – it would be worth $649,300 today.

Warren Buffet shares my sentiments in his upcoming annual letter to Berkshire stockholders.

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

Mr. Buffet goes on to explain that cash is a necessary evil due to the need for liquidity.

Beyond the requirements that liquidity and regulators impose on us, we will purchase currency-related securities only if they offer the possibility of unusual gain — either because a particular credit is mispriced, as can occur in periodic junk-bond debacles, or because rates rise to a level that offers the possibility of realizing substantial capital gains on high-grade bonds when rates fall. Though we’ve exploited both opportunities in the past — and may do so again — we are now 180 degrees removed from such prospects. Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”

He then continues on, discussing other options investors tend to flock to, such as gold.

Near the end of the letter, the Oracle of Omaha gives us a glimpse of why he is one of the best investors in the world:

Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort.

I would guess that most people who are heavily invested in currency-based assets do so because someone somewhere at some point told them it was a safe investment. Being afraid of all of the uncertainty in the economy, they run to their “safe” investments so they can sleep at night.

I would further guess that, with a few exceptions, they don’t truly understand why they have their money invested there.

Risk free investments do not exist. Don’t buy into the fear that the media spreads and park your money in low-yield cash-based investments because they make you feel safe.

Unless you have an immediate need for liquidity, your money should always be working for you in the market. Not parked in a bank account being eaten away by inflation.

Other than for liquidity, do you think there is ever a reason to invest in low-yield currency-based assets?

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2 Responses so far.

  1. Lauren says:

    Great article! I’ve been hesitant myself to invest because I’m scared of all the fraud out there. This post reminded me of a book I just finished reading, The Vigilant Investor. The book is about how to make smart investments so that you can watch your money grow without the fear of losing it.

  2. After a cataclysmic market event it’s no surprise that people are hesitant, to the point of taking an extreme allocation in fixed income. The fear is that too many people end up over allocating in fixed income and never meet their investment goals because of it. Which seems to be the case so far. It may help calm their emotions but the long term growth potential is non existent.

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