Risk Free Rate of Return

Does such a thing really exist? The answer, if it has not been made clear over the first six months of 2011, is no. There isn’t such a thing as a “risk free rate of return”. There is the illusion of a return with no risk…in the form of FDIC guarantees or based on the full faith and credit of the ___________ government. But there is no such thing as a risk free rate of return.

Any risk that is purported to be protected or guaranteed against ultimately has a guarantor of last resort. Insurance companies offer guarantees based on the financial strength of a re-insurer, who shares in the risk of the promise or coverage the original insurance company makes.

The FDIC guarantees bank depositors up to a certain amount, and even though this agency is essentially insolvent, with the backing of the full faith and credit of the United States Government, the agency is able to protect bank deposits of all customers – So far.

The Greek Government is an excellent proxy for the reality that there is no such thing as a risk free return. If any person, agency, or government makes short-sighted or stupid decisions such as borrowing too much money, the ability to pay that money back is compromised. This is true of individuals who use their credit cards too much. This is true of companies who borrow too much. And this is also true of governments which borrow too much.

A few individuals are able to file for bankruptcy without destroying the entire system because (at least heretofore) more people are wise with their money, which enables the system to absorb their losses. But when too many people file or the system is itself unstable, the ability to pay is compromised.

This leads to two important points:

1) Any financial/investment process, strategy, or system which uses a “risk free rate of return” as it’s foundational building block, is flawed; Perhaps significantly so. You have “heard” me speak disparagingly about just such a system – it’s called Modern Portfolio Theory (MPT) or by its more common moniker – asset allocation. In the past we’ve discussed the myriad ways MPT is non-sense and this is just one more reason. This contributes, and perhaps even directly caused, the investment losses many people took in 2008-2009. The retirement advice you rely on simply cannot be based on this flawed notion of finance.

2) When foolish capital/investment/financial decisions are made for a long enough period of time, even entities which were once considered invulnerable, impregnable, and lock-down-safe are compromised. When those entities are composed all bets are off, especially any placed or made based on the concept of a risk free return!