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Re-assessing what risk-free actually means

The last few years have demonstrated that the concept of risk free assets needs to be looked at again

There is, and has never been, such a thing as a risk free asset or return. The concept is a very useful way of benchmarking the attractiveness of different asset classes.

In other words, it helps investors to decide whether the extra return offered by particular types of asset e.g. emerging market equity is sufficient to compensate for the extra risk compared to say a deposit with a well-capitalised bank or a gilt of an appropriate term. In this sense the return on a “risk free” asset remains extremely useful.

But for the private investor, the concept of a risk free asset can be a dangerous illusion because as we have seen nothing is risk free.

Banks can fail, government bonds can be downgraded, in some circumstances like Greece to junk status, and ultimately Governments can default as Argentina did in 2002.

The best we can say is that some risks are very small or remote. Events can change our perception of risk, particularly unpredictable events. What may be a very small or negligible risk over six months or a year cannot be discounted over the longer term.

We only have to recall the Icelandic banks which were perceived as offering a high “risk free” return until it became apparent that it wasn’t risk free after all!

Even without the impact of events (predictable or otherwise), the relative riskiness of different types of investments depends on the investment term.

This variability is not consistent from one asset class to another. Some investments will become relatively less risky as the investment term increases and other will increase in risk.

Cash deposits, which are considered risk free for short investment terms, become increasingly risky the longer they are held and therefore cease to be “risk free”.

The charts show the volatility of annual cash returns. The chart on the top shows the change in the base rate over the past 30 years. As a result, the volatility of cash over three, 10 and 30 years is 0, 2 and 4 per cent respectively.

The chart on the right compares how the cash return volatility over three and 10 years has varied over time.

What is clear is that the volatility of cash returns almost always increases as the investment term increases with the result that cash cannot be considered to be risk free for anything other than very short investment terms.

eValue graph 4 April 2013

Bonds, on the other hand, behave very differently.

A bond’s riskiness will be at its lowest when its term matches the investment term. The risk for shorter and longer investment terms will increase with the divergence from the bond’s duration.

In short, the relative riskiness of a bond initially falls as the investment term increases and then starts to rise. A similar effect will occur with a bond fund.

Clearly the choice of risk free asset depends on the investor’s anticipated investment term and if this changes, the risk free asset may need to change.

Another complication for the private investor looking for risk free assets is to define the perceived risk.

The simplest definition is the risk of capital loss and traditionally a cash deposit or an AAA government bond matching the investment term has been the answer.

Gold has long been considered the ultimate risk free asset and preserver of wealth but fear can drive its price a long way above its intrinsic worth as happened immediately after Lehman Brothers bankruptcy. Purchasing at the wrong time can destroy rather than preserve wealth.

For people who fear having to flee due to political uncertainty or persecution, precious stones are the risk free assets of choice because they are easy to transport.

In less extreme situations investors will have normal goals such as retirement saving, mortgage repayment or funding education fees. For each of these, investors may see the risk they face differently and this will change their risk free assets.

For example, the retirement investor may be concerned about inflation and here the risk free asset is an index linked bond. Because indexed linked bonds are in high demand by large final salary pension plans, they offer a very low return.

Individual investors, typically, decide that the extra return offered by equity investment more than compensates for the extra risk.

Generally using risk free assets to meet personal investment objectives is a very expensive option and consequently not widely adopted.

Where risk free assets come into their own is in helping investors make judgements about the risk reward trade-off. Stochastic forecasts are extremely effective in helping investors make this type of decision.

Bruce Moss is strategy director of eValue


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There is one comment at the moment, we would love to hear your opinion too.

  1. surely holding cash under the FSCS savings protection makes cash risk free to a certain limit

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