The reason we invest money is that we don’t need it right now, and we give it to other people to use until we need it back. These other people are called counterparties. Depending on what our counterparty does with our money, we expect a certain rate of return.
Risk is essentially the probability that our expectations are not met. We can be disappointed in a number of ways.
First, our counterparty could fail to return our money. In the case of debt instruments, the borrower could default. In the case of stocks, the company could go bankrupt. In many cases, however, we don’t really expect the counterparty to return our money directly to us.
Corporations might pay dividends to us. Still, we expect to get the main part of our money back by selling the stock to someone else at a later time. Similarly, we might buy a 20-year bond and expect to sell it after five years.
This is the second potential source of disappointment. Even if the counterparty is doing fine and making good use of our money, we might not be able to get all of our money back if we have to find another investor to buy us out.
The prices jump all over the place even if nothing is really changing at the counterparty. We see this in the daily market quotes for stocks and bonds.
The final risk is that we might receive back all of our money, plus the expected return, only to find that inflation has discounted the dollars we receive. If our investment paid a 5-percent return and inflation ran at 7 percent, we lost 2 percent of our money. The counterparty held up its end of the agreement, yet we are still disappointed.
We have three key risks to navigate: Repayment, market value and inflation. With these risks in mind, what is the safest investment we can make?
The first risk, repayment, can be overcome by buying only the highest credit quality investments. The gold standard is U.S. Treasury obligations. Fully guaranteed obligations of the American government are the most credit-secure investments in the world.
The second risk can be overcome by matching the maturity of the investments to the dates on which the money will be needed. If college tuition is due in 10 years, then an investment that matures in 10 years immunizes the risk that the investment will need to be sold early. Our investor could care less if anyone is going to come along and buy the investment at a good price.
Finally, our investor needs to think about inflation risk. Fixed income investments lock in a rate of return, and unexpected inflation could wipe out those returns. Stocks have a poor track record of keeping up with unexpected inflation over time horizons of less than 10 years or so.
Short-term instruments such as money markets and Treasury bills will keep up with inflation, but only just barely. There won’t be anything left over after inflation and taxes. A net zero return is all that we should expect from short-term investments.
In selecting the safest possible investment, we want something that is secure, that matches our time horizon and is guaranteed to stay ahead of inflation. The only investment meeting these criteria is inflation-protected Treasury bonds, or TIPs. I’m not suggesting that you fill up your portfolio with TIPs, but you should consider them for parts of your assets as the ultimate safety net. TIPs are available in various maturities and as savings bonds.
But, here’s the rub: You need to be patient. If you buy a 10-year TIPs bond at a quoted real yield of 2 percent, you are absolutely, positively guaranteed to receive your money back after 10 years at a total return of 2 percent above the rate of inflation. That much is certain.
Even the safest investments require that investors be patient.