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Is risk-free really risk-free?

Let‘s start with a clear answer to that question: No investment is 100% free of all risks. However, some investments come far closer to being risk-free than others. Examining the closest approximations available can serve as a useful benchmark for evaluating other investment options that involve taking on greater risks.

Think of looking at "risk-free" returns as establishing a baseline. By understanding the most you could expect to earn from an ultra-safe investment with minimal risk, you can then compare that to the potential returns and risks of other investment choices available to you. This can help you make informed decisions about what levels of risk you are comfortable accepting to pursue various investment goals.

Now that we‘ve defined the purpose of examining near risk-free investments, let‘s take a closer look at which asset classes come the closest to filling that role, and the limitations even they have in fully eliminating risk.

As close as it gets: U.S. Treasury Securities

For U.S. investors, short-term U.S. Treasury bills are generally considered the closest you can get to a risk-free investment.

Here‘s why T-bills are viewed as close to risk-free:

  • They are backed by the full faith and credit of the U.S. government, which has an exceptionally strong ability to meet its debt obligations.

  • There is minimal risk of default given the U.S. government‘s powers to raise revenue through taxation and borrowing.

  • T-bills can be quickly and easily converted into cash with very high liquidity.

  • They tend to maintain principal value, even in times of stock market volatility and downturns.

However, even U.S. Treasury securities have some inherent risks to be aware of:

  • Interest rate risk – Falling market interest rates can reduce the value of bonds you hold, as new bonds are issued at higher yields.

  • Inflation risk – Rising inflation can reduce the real purchasing power and value of interest payments received.

For example, suppose you purchased a 10-year Treasury bond yielding 2%. Seems low risk, right? But higher than expected inflation could seriously erode the real return and value of that bond over the next decade.

To demonstrate, take a look at how 3-month T-bill yields have compared historically to inflation rates in the U.S. going back to 1950:

Year3 Month T-Bill YieldInflation Rate

Inflation was higher than T-bill yields during parts of the 1970s, 80s and 90s. This resulted in negative real returns for investors during those periods, even though they had put their money into an asset class considered closest to "risk-free".

This demonstrates that variables like unpredictable inflation introduce risks not captured by a security‘s nominal yield. Let‘s look at other ways your purchasing power can be eroded over time.

Inflation eats away at "risk-free" returns

Inflation varies but has historically averaged around 3% annually in the U.S. As we just saw, it can exceed T-bill yields for extended periods.

Cash equivalent investments like T-bills do not compensate for long term loss of purchasing power against inflation. To illustrate, suppose you invested $10,000 into a 5-year T-bill yielding 2%. After 5 years at 2% interest you would have $10,402.

But if inflation ran at 3% per year over the same period, the real world value and purchasing power of your original $10,000 would have declined to around $8,636 in today‘s dollars.

This dynamic shows that:

Nominal Return – Inflation Rate = Real Risk-Free Return

As an investor, you need to earn a positive real return just to maintain purchasing power, not simply get your original nominal investment dollars back.

So while T-bills provide an annual return and guarantee of principal, they do not guarantee you will maintain real purchasing power, especially over longer terms.

Dangers of ultra-low rates for savers

Since the 2008 financial crisis, central banks have taken unprecedented steps to push risk-free rates near zero. This has helped stimulate economic growth but also created risks for investors relying on fixed income.

"With interest rates so low, retirees need to be very cautious about consuming their nest egg too quickly," warns Michelle Gessner, a certified financial planner. "Rates below 2% don‘t support a 4% withdraw rate for someone expecting a 30 year retirement. volatile inflation only adds to the risks".

Prolonged periods of low risk-free rates make it difficult for retirees and savers to earn enough fixed income to maintain their standard of living or grow their nest egg. Let‘s look at some of the dangers ultra-low rates pose:

  • Very low yields on savings reduces income generation.
  • Rising rates could reduce bond principal values.
  • Negative real returns after inflation eats away at purchasing power.
  • Incentivizes taking on riskier investments like stocks to seek higher returns.

"With Treasuries paying so little, retirees are increasingly moving into riskier assets in search of income," says Kevin Lao, a certified financial analyst. "But many don‘t fully appreciate the risks they are taking on until volatility hits their portfolio."

This demonstrates how periods of extremely low risk-free rates can actually jeopardize the financial security of savers and retirees over the long run.

Reaching for yield in riskier fixed income

With savings accounts and Treasuries paying so little, where have some investors turned in search of higher yield? Higher risk segments of the bond market, like:

  • Corporate junk bonds
  • Emerging market debt
  • Longer maturity bonds

Junk bonds issued by less creditworthy corporations can offer yields of 5% or higher. But they carry commensurately higher risks of default if the economy deteriorates. Over 1 in 10 junk bonds default within 5 years of issue.

Emerging market bonds in countries like Turkey, Brazil and South Africa also pay higher yields around 5-9% on average. But currency devaluations and political risks can quickly erase those gains.

Longer maturity bonds above 10 years duration pay incrementally higher yields but have much higher interest rate sensitivity. A 1% rise in rates could inflict a 10% or greater drop in the bond‘s market value.

Reaching for yield in these riskier market segments exposes investors to risks they are often not adequately compensated for. Attempting to make up for low risk-free yields this way can seriously impair portfolio stability.

Can any investment be risk-free over the long run?

Over multi-decade periods, even ultra-safe investments like Treasury securities carry risks that emerge over time:

  • Extreme tail risk events – Hyperinflation, natural disasters, global conflict, pandemics. These "black swan" events are unpredictable.

  • Opportunity cost – Locking money into fixed low returns forgoes potentially higher gains from stocks over decades.

  • Political and legislative changes – Tax policies, interest rate shifts can alter expected returns.

"Even Treasuries won‘t assure real returns above inflation over an investor‘s lifetime," cautions David Edwards, financial author and risk management expert. "Diversification across asset classes including equities becomes necessary to mitigate risks no one asset can eliminate."

The bottom line is that no investment or asset class can be considered truly risk-free over multiple decades an investor needs their money to last.

"Risk-free" assets can still carry undetected risks

During the mortgage crisis of 2008, AAA rated mortgage-backed securities were considered safe investments by ratings agencies and investors alike. In hindsight we know they actually harbored far greater risks than almost anyone realized at the time.

This serves as an important reminder that investments perceived as virtually risk-free in the present can still entail risks that take time to fully emerge. Past performance and assumptions provide no guarantee future risks won‘t arise.

Some investments, like Treasuries, may be less susceptible to these unforeseen risks given the stability of the issuing entity. But investors should be wary of assuming any asset is "risk-proof" based on its historical track record alone.

Mitigating risk through diversification

While no investment is completely risk-free, you do have strategies to mitigate risks:

Diversify across:

  • Asset classes – stocks, bonds, real estate, alternatives
  • Market segments – US, international, emerging markets
  • Industry sectors – tech, healthcare, utilities, materials

Balance stocks and bonds to target your risk tolerance:

  • Bonds reduce portfolio volatility from equities.
  • Determine your ratio based on risk appetite and stage of life.
  • Rebalance to maintain target allocation.

Example portfolio allocation for a retiree:

  • 50% bonds – Income stability
  • 30% US stocks – Growth potential
  • 10% international – Diversification
  • 10% alternatives – Inflation hedge

Maintain emergency fund so you don‘t have to sell assets at losses

  • 3-6 months expenses in cash
  • Avoid liquidating investments during downturns

A diversified portfolio tailored to your risk tolerance and goals accounts for a variety of risks while still providing opportunities for growth.

Evaluating new alternative assets – crypto

In recent years, risk-seeking investors have poured money into new alternative assets like cryptocurrencies in search of potentially higher returns. But these emerging options harbor risks that are not yet fully understood.

Bitcoin and other cryptocurrencies promoted as "digital gold" have seen extreme volatility, with prices rising and falling by over 50% within short periods. They introduce risks like:

  • Extreme volatility
  • High transaction fees
  • Cybersecurity threats
  • Uncertain regulation
  • No underlying cash flows

Many financial advisors recommend limiting exposure to crypto to less than 5% of your overall portfolio until the risks and rewards become clearer.

While the blockchain technology behind cryptocurrencies holds promise, savers should be cautious treating it as any kind of risk-free replacement for stable returns.

The bottom line

No investment is completely free of any kind of risk over the long run. However, Treasury securities provide the closest thing available to a baseline near risk-free rate of return. This serves as a benchmark against which to evaluate other investments that require accepting greater risks.

Investors seeking higher returns inevitably must take on greater risks. But risks should be understood and mitigated through diversification. By controlling risks rather than seeking to avoid them completely, you improve your changes of achieving financial goals for retirement, education, or other priorities.



Michael Reddy is a tech enthusiast, entertainment buff, and avid traveler who loves exploring Linux and sharing unique insights with readers.