What would you do if the risk-free rate was 7%?

While it’s a cliche to say that investors have short memories, I’m frequently surprised to realize just how short most people’s memories are:

• I’m old enough to remember when the United States was running a budget surplus and the chairman of the Federal Reserve endorsed a tax cut because of the risk of the debt falling too low.
• I’m old enough to remember when mortgages were so easy to obtain that “flipping houses,” literally just waiting for local real estate prices to increase before selling a piece of property onward to the next speculator, was treated as a legitimate business enterprise.
• And I’m old enough to remember when PayPal offered a money market account paying over 5% APY on your entire balance.

I do not know if we will ever see such a high interest rate rate environment again. To get there from here would require 4 years of economic growth with a 1 percentage point rise in rates each year, 2 years of economic growth with a 2 percentage point rise in rates each year, or 1 year of economic growth with a 4 percentage point rise in interest rates this year. I don’t think that will happen, and indeed I don’t think the United States will ever experience 5% APY interest rates again.

But what if it did?

 

What is the point of investing?

This is a post that I’ve thought about writing in a number of different ways, and that I suspect I will write in a number of different ways. The fundamental question I’m interested in is this: what is the point of investing? Is it to achieve lifetime spending goals, with a margin of safety based on the risk of an unexpectedly long lifespan? Or is it to accumulate as much money as possible?

Establishing an objective is essential if you’re to identify what behavior is most likely to achieve your objective. This may sound trivial, but is in fact absolutely essential to the entire enterprise of investing. Consider the following two scenarios:

• A person making $25,000 per year wants to retire in 30 years with $1,000,000 in savings;
• A person making $1,000,000 per year wants to retire in 30 years with $1,000,000 in savings.

The first person needs to save 57% of their income compounded at 5% per year for 30 years to achieve their goal. The second person needs to save 10% of their salary compounded at 0% per year for 10 years to achieve their goal.

There is no reason for the second person to take any risk at all with their savings: They can easily achieve their savings goal through mechanically adding to their savings each year from current income.

Don’t scoff at the risk-free rate of return

 

Today, the risk-free rate of return is about 0.91%. That’s the rate of return that you’re guaranteed, in inflation-adjusted dollars, by buying a 30-year TIPS bond today.

That’s very low!

On the other hand, it’s guaranteed to keep up with inflation, and a million dollars is a lot of money. It seems perfectly reasonable to me that the first million dollars a millionaire earns should go into a 30-year TIPS bond that’s guaranteed to keep up with inflation. That way, in 30 years, they’ll still be an inflation-adjusted millionaire no matter what happens.

On the other hand, the first saver above can’t settle for a 0.91% APY real yield. Saving the same 57% of their income as above, after 30 years they’ll have just $496,000 in savings, over 50% short of their goal. “Clearly,” that saver needs a more aggressive investment portfolio, including domestic equities, international equities, emerging markets, real estate, and whatever else you think belongs in a “balanced, diversified portfolio” or whatever today’s nostrum is.

But what if the 30-year real yield on TIPS was 5%? Of course if the risk-free rate were that high, you’d have to assume stocks were badly beaten down, the world was in a state of depression or war, and blood was in the streets — the perfect time to invest in an aggressive portfolio. But why? If your goal can be achieved with less risk, what is the purpose of taking on more risk?

There are many possible answers. Here are a few:

• To spend more in the present. If you can exceed your investment goals by taking on more risk, you can reduce your savings and spend more out of current income. This is sometimes referred to as “lifestyle inflation,” a term that always makes me chuckle.
• To increase your margin of safety. Remember we’re talking about inflation-adjusted dollars here, but certainly you may decide over the course of your investing career that one million dollars really isn’t enough to retire on, what with the increasing cost of prescription drugs, the war on health insurance, the deportation of our low-wage nursing home workers, etc. If you think you can accumulate $1.25 million, why not do so in order to be on the safe side?
• To pass down a larger estate to your heirs. Many people want to leave their partners and dependents a heap of money after they find out what happens next. If that’s your goal, then your investment portfolio might be perpetually focused on earning a rate of return above the risk-free rate.

What will you do if you achieve your financial goals ahead of schedule?

Pick a large-capitalization stock today and you’ll find someone has written an almost identical cliche about it:

• “An investment of $1,000 on Berkshire Hathaway’s estimated 1964 stock price in 1964 would have generated over $9.98 million.“
• “if instead of paying $2,495 for a Macintosh in 1984 and customers put that money into Apple stock, their shares would now be worth $715,943, or more than $710,000 after fees.“
• “if you would have invested $5,000 in Walmart stock (WMT) at the beginning of 1976 and reinvested all your dividends into more Walmart stock, 30 years later you would have over 5.4 million dollars today.”

These are literally just the first three companies I thought of. My question is, what if you do buy the Berkshire Hathaway, Apple, or Walmart of tomorrow and see your investment soar beyond your wildest dreams? Should your goals change as your net worth does? Maybe $1,000,000 sounds like a lot of money, but if you reach that amount of savings at age 40, maybe you’ll decide that a million dollars actually isn’t cool — a billion dollars is.

If the risk-free rate of return were 7%, your financial advisor’s charts would be correct

Google “benefits of compound interest” (I did) and you’ll find some inspiring charts about the value of your account, smoothly sailing upward over time as the interest on your interest makes you wealthy beyond your imagination (not to mention right on schedule). And then if you zoom in close enough, you’ll see some fine print tucked away somewhere reading “assumes a 7% annual return.“

Assumptions, as I like to say, are fun. But what if the risk-free rate of return really were 7%? What if you could lock in those inflation-adjusted returns for years or decades? What purpose, then, would a diversified, well-balanced portfolio of stocks and bonds serve?

Conclusion

All of this brings me back to the question posed in the title: what would you do if the risk-free rate were 7% APY? Would you save less? Would you retire earlier? Would you chase riskier assets in pursuit of a “risk premium” you don’t need? Or would you sit back and actually watch your assets climb your financial advisor’s compound interest graph?