Tuesday, December 1, 2009

Reflection: Is there such thing as risk free investing?

Are you a risk adverse person? Are you looking for risk free investing? If you are, you have to consider carefully the definition of risk free investing.

Everyone who studies corporate finance will have to understand the CAPM formula (Capital Asset Pricing Model). One of the most important factor in CAPM is the risk free rate.

This CAPM formula implies that there is risk free investing . The risk free rate refers to the rate of return from government bond. The idea is that it is safer to invest in government bonds, since government bonds supposedly do not default. Many people think that investing in government bond is the safest form of investing.

However, there is no such thing as risk free investing. From the sorry example of Russia and Argentina, we can see that risk free investing is not that safe. Even Dubai is near bankruptcy, those investors holding the sovereign debt must be having a hard time falling asleep.

So far, the US government has no history of default on Treasury bond. Many people still consider investing in the US Treasury bond as risk free investing. However, given that the US government has been incurring debt at an alarming rate, it is questionable how long risk free investing can remain risk free.

Default risk is one of the risk factor in supposedly risk free investing. Obviously the US government will not want to default on its debt. The problem in risk free investing is that: Will the US government able to service all the debts maturing in the next thirty years? The more likely scenario is that the US government rolls over the debt by issuing new bond when it is time to pay debt.

Investing in government bond, even when there is no default risk, is not really risk free investing. There are many risks in supposedly risk free investing, such as interest rate risk, yield curve risk, reinvestment risk, inflation risk, exchange rate risk, volatility risk and other risk.

If you are studying corporate finance , do not be misled by the term “risk free rate”. There is no risk free investing in this world.

The only thing about supposedly risk free investing is that you are unlikely to lose all your money. The example of Russia, Argentina and Dubai are extreme and rare examples. That is why the return on risk free investing is very low.

The CAPM formula shows that investors in equity want a higher rate of return on stock market investment. Stock market investment is inherently more risky than risk free investing. Everyone who pumps money into the stock market investment must be prepared to lose money. Even when investors invest in index funds and mutual funds, they can lose money when they sell at the wrong time. The value of index funds and mutual funds can decline rapidly in a stock market crash.

All great investors do not become rich from pouring all their money into risk free investing. All great investors become rich because they take calculated risk and they know when, how and what to buy and sell. Even then, they lose money from time to time.

Risk free investing is a myth. The CAPM formula needs a risk free rate for comparing the equity and bond risk and return. Otherwise, there is no way to compare government bond and equity investment.

Many Singaporeans do not invest in bonds issued by Singapore government. The ironic fact is that Singapore is so rich that it does not need to issue bonds to raise money. Singapore government issues government bonds to provide opportunity for investors to participate in risk free investing. The interest rate is so low that many people prefer to sink money into stock market investment, even though they don’t know anything about stock market investment. Many of them end up getting burnt. Risk free investing is better for them, yet they rather take the chance of losing money.

For those who want to participate in stock market investment, it is better for them to spend time and money studying and understanding the market. It is very costly to lose money in stock market investment. Otherwise, just buy government bond.


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