It is critical to understand that when groups of assets are collected together into a portfolio, the risk and return behaviors are completely different from any one of the assets that the portfolio contains. Thinking about individual assets within a portfolio can be a grave mistake.
It is a basic truth of investing that if you don’t take on any risk, you will not have any reward (it may seem so in some cases, but subtract inflation and taxes out, and the return vanishes). When we take on risk in the probabilistic environment of security markets, we can and will lose money from time to time. There is no way around this unpleasant truth. If someone promises you wealth without risk, they are wrong.
When professional portfolio managers (and finance professors) talk about the relationship between risk and rewards, they usually talk about the rewards in terms of expected returns. Investors expect to make a profit from investments in securities like stocks and bonds because they are taking on risk. Expected returns are different from actual returns.
We can’t possibly predict the actual return of an investment for a future period, so we have to estimate it with data that we do have. This means that the SEC’s warning about past performance not being indicative of future performance is tossed out the window. We have no choice but to model future return expectations on past returns. As you would expect, these returns are in no way guaranteed. Thus, they are merely expected (and probable).
Market prices reflect changing investor attitudes about future risk. Unless you are investing in cash, you are always speculating to some degree because being long any security means you believe it will go up in value. When the perceived risk of a security goes up, the price of owning the investment will go down. Conversely (all else being equal), when the perceived risk goes down, the price goes up. Different assets have different susceptibilities to different risks.
Risk Components for Different Assets
|Cash||Inflation + Taxes|
|U.S. Treasury Bills||Inflation + Taxes|
|U.S. Long-Term Bonds||Inflation + Taxes + Interest Rates|
|Corporate Bonds||Inflation + Taxes + Interest Rates + Default|
|T.I.P.S.||Taxes + Interest Rates|
|Stocks||Market Risk + Individual Stock Risk|
Finance professionals refer to Treasury Bills as the risk-free investment, although this is not strictly true. T-bills have inflation and tax risks, but they are the closest thing you can get to risk-free. T-bills are an excellent proxy for a money market fund because money market funds are often composed of T-bills. The life if a T-bill is so short that its value is not altered by changes in interest rates. There is no coupon for a T-bill; you buy it for a discount and then redeem it for face value when it expires.
In high inflation environments and very low-interest rate environments, investors in T-bills actually lose money because of the corrosive effects of inflation. This is why money market funds are generally a bad investment at present, and that isn’t likely to change any time soon. For about thirty or so years, Americans have been paying the federal government to borrow money from us. Our interest in the risk-free “investment” is mostly as a sort of benchmark to which we can compare other combinations of risks and returns.
Last Updated: 6/25/2018