There is No Such Thing as a Risk-Free Lunch
By Paul Copeland, CFA
Like many people, I was surprised by a refund check from my insurance company as COVID-19 stay-at- home orders have led to fewer accidents. While I’m driving much less, I do drive to the supermarket as I’ve had more opportunity to make meals these last few months. Driving is the number one cause of death in most age groups, so while gathering food is probably safer today than in previous centuries, it’s not without risk. Even with many precautions supermarkets are taking, the risk of catching the corona virus is staring me in my masked face while I’m picking out food. Accident and disease are not the only risks I think about either. There’s the risk of rejection as my kids remind me in subtle and not- so-subtle ways that Mom’s a better cook. To please the young judges, I’m tempted to cheat and add lots of butter and/or sugar. Thankfully, my wife has educated me to the long-term risks of unhealthy foods. My colleague, Todd Gray, can confirm that unhealthy foods have short-term risks as well. He almost died choking on a chocolate truffle. We might tell Todd to eat more kale, but he could easily choke on that too.
The last few months have reminded me that investments are like my lunch. There’s risk in whatever I choose. We were reminded of the risks of stocks on March 9th when the S&P 500 index was down 7.6%, and again three days later on the
12th (down 9.5%). After a weekend break to enjoy some social distancing, we were hit with another punch in the stomach on the 16th (down 12%). In just over a week, we experienced 3 of the 20 all-time worst daily percentage drops for the S&P 500. To be fair to March 2020, it wasn’t all bad in the markets. On the 13th and 24th the S&P regained about 9.3% and 9.4%, respectively, both days registering among the 20 all- time best daily percentage increases for the S&P. These movements up and down were impossible to predict and often difficult to explain, even in hindsight. Many positive days in the market coincided with negative economic news. After a 34% drop in the S&P from the high point through March 23rd, and the 9.4% increase on the 24th, one of the front-page headlines from the NY Times read: “Coronavirus in N.Y.: ‘Astronomical’ Surge Leads to Quarantine Warning”. Many braced themselves for another market drop, but instead, stocks climbed almost 30% over the following six weeks.
We were likewise recently reminded of one of the many risks in bonds – credit risk. Corporate bonds displayed this risk with companies such as JCPenney filing for bankruptcy. This risk was also discussed in government issued bonds. The most memorable example was the political rhetoric suggesting that maybe states should consider bankruptcy. There is also the more likely possibility that certain municipal revenue bonds could have trouble making payments. Meanwhile, many developing countries don’t have the healthcare and other resources to deal well with COVID-19. Investors are questioning some governments’ ability and willingness to repay debt during a crisis.
The risk in “risk-free assets” is not as striking, but it is very real. The 3-Month Treasury Bill is often used as the risk- free rate. Early June it was 0.15%. A year ago, the yield was 2.28%. The rate on cash invested in money markets is similar. For some investors there is a short-term risk referred to as FOMO (Fear Of Missing Out). They liquidate their cash stores, typically used to cover near- term expenses, in order to jump into the surging stock market. The last few months have led others to sacrifice long-term growth potential to sit in a perceived bunker of safety, where the very real risk for them is the long- term negative impact of inflation.
I recently bought a plane ticket to Chicago for my 25- year college reunion (that may or may not happen) this fall. The ticket was cheaper than many of the same flights I took more than 25 years ago. Similarly, present computer costs are about 20% what my computer in college cost. Yet while some items do get cheaper due to better technology, the overall cost of living continues to rise. The dollar from when I started college is worth about 52 cents today. Sometimes it’s easy to forget about inflation, but it is a very real risk to people’s ability to meet financial goals, such as helping kids or grandkids with their education. Tuition at my college has risen about 400% since I was there.
While inflation has come down this past year (and it’s only been this low a few times
in the past 50 years), it is still at 1.4%. Subtract this from the risk-free rate of 0.15% and you are losing out every year. This negative real yield can go positive, as it has often been historically, but a low interest rate environment highlights the risk of inflation to “risk free” investments. More discouraging for investors looking for safety is that the 10-year Treasury is only yielding about 0.7%. Therefore, the safe bet is that adjusted for inflation, you will lose money by investing in a US Treasury Bond maturing in 2030.
Life is full of risks. While we can’t eliminate all risks in our lunch, we can mitigate them by doing things such as wearing a mask at the supermarket. Likewise, we can lower risks in our financial “lunch” by allocating assets with time horizon in mind, knowing that the stock market has greater short-term risk and the money market has greater long-term risk.
Money needed in the next few years should be kept in stable investments (cash and short-term bonds), with low chance of losing value. This allows other money to stay invested in a longer-term allocation of stocks and fixed income that should beat inflation and increase the probability of meeting longer term goals.