The Role of Risk-Free Assets in Your Long-Term Portfolio
What is a risk-free asset, and what role should it play in your portfolio?
That’s one of the first questions many investors ask when struggling with the asset allocation question.
In today’s market environment, the sudden and steep drop in the stock market as well as anxiety over the future of the banking industry and the financial health of long-term bond issuers have all caused a massive rush to—and an exclusive focus on—“risk-free” assets.
Yet only two years ago, these assets appeared “boring” to many investors who—at that time—were focused on the long-term return and current income attributes of the major asset classes (stocks, bonds and cash).
But neither of those perspectives produces a useful guideline. Instead, the role these assets play in your portfolio should be based on a perspective that encompasses both long-term and short-term considerations.
What Asset Is Risk-Free?
In the investment world, risk is typically associated with uncertainty in terms of returns: The greater the uncertainty surrounding future returns, the greater the risk. A risk-free asset is one with a certain future return.
In the real world, short-term Treasury bills come as close as possible to being risk-free because they are backed by the U.S. government (no credit risk), and because their maturities are short (no interest rate risk—the risk that changes in interest rates will cause the underlying value of the security to change).
For these reasons, Treasury bills are often used by investment theorists and analysts to define a “risk-free asset.”
For individual investors, Treasury bills offer the most complete protection in terms of credit risk, but other “cash” investments (low-risk money market funds, short-term CDs, etc.) are practical alternatives.
No Such Thing as No Risk
While these assets offer real protections over short-term horizons, it is important for long-term investors to keep in mind that, despite the risk-free label, Treasury bills and other short-term cash investments do contain two very important long-term risks:
- Inflation risk: The long-term returns from Treasury bills and cash investments have been the lowest of the three main asset classes, offering virtually no growth above the rate of inflation. For example, since 1926, the long-term real (after inflation) rate of return on Treasury bills has averaged roughly 0.7% annually. Taxes can take a further bite out of returns. Thus, if cash is held in a taxable account, your aftertax return could easily be below the rate of inflation.
- Income risk: Treasury bills and cash investments face the risk that the income provided will fall sharply in a relatively short time, in tandem with declining short-term interest rates. Short-term interest rates are much more volatile than long-term rates over time. For example, returns from Treasury bills climbed from 4.9% in 1977 to 17.1% in 1981, they declined to 8.7% in 1983, and in 2008 they averaged a mere 2.0%. In mid-March 2009, three-month Treasury bills were yielding 0.45%.
Putting It Into Perspective
Treasury bills and other cash investments have the advantage of liquidity and little downside risk, but no real long-term growth, and typically the income is the lowest among fixed-income alternatives. The investment attributes allow cash to serve several purposes within an investor’s portfolio:
- It serves as a ready source for spending money and for protection against emergencies, so that longer-term investments need not be liquidated at inopportune times.
- It serves as a stabilizer for your overall portfolio, tempering the overall downside risk of what may otherwise be a very volatile portfolio.
Spending & Emergencies
What’s the minimum amount individuals need to keep for spending and emergencies?
One popular rule of thumb is that cash reserves should equal six months’ to a year’s worth of take-home pay or living expenses. But this rule of thumb applies primarily to people who are working.
Individuals who are working really don’t need to maintain a large “spending” account, since they have a ready source of monthly income to meet expenses. The amount needed for spending is a function of personal preference in terms of how much you desire to have on hand to meet expenses, particularly for upcoming major purchases.
On the other hand, individuals who are working do need emergency cash reserves to protect against a major loss—primarily a loss of income due to loss of work or disability.
Assuming you are properly insured, disability insurance should eventually cover most of any income shortfall due to a disability. In this case, your primary liquidity need would be during the waiting period when there are no disability benefits; the shorter the waiting period, the less there is a need for liquidity. On the other hand, a loss of income may occur that is not covered by disability insurance—for instance, a cutback or firing. If this were to occur, you would need enough income to offset expenses over the time you are out of work. The best way to determine this liquidity need is to estimate your monthly living expenses and assume that those expenses need to be covered for some time—six months to one year.
Retirees have somewhat different emergency and spending needs.
While the financial emergency that threatens workers is the loss of salary income, a retiree living off of investment income is concerned with fluctuations in savings due to the volatility of the markets.
The major protection from this risk is a diversified asset allocation plan, which includes a large enough commitment to low-risk liquid cash assets so that you are not forced to sell stocks or longer-term fixed-income assets during a protracted market downturn.
For example, if you want to protect your longer-term assets from forced sales over a five-year period (roughly, a full market cycle), and you plan on withdrawing 4% of your investment portfolio in your first year of retirement for income, you would want to allocate at least 20% of your investment portfolio to low-risk liquid cash assets.
Of course, retirees who are living off of investments also need cash accounts from which to withdraw spending money. The size of this cash reserve would depend in part on the frequency with which you rebalance your investment portfolio and add to your spending account. Less frequent rebalancing may be more convenient—and less time-consuming at tax time—but it will cause the spending account to fluctuate more. Whether this cash account is combined with the cash reserves used to protect your longer-term assets against having to sell at inopportune times is a matter of comfort and convenience.
A separate function of cash within an investment portfolio is to temper portfolio volatility that is the result of investments in riskier asset classes.
In general, stocks provide the most growth. Bonds and cash produce a steadier source of income than stocks do; a much larger percentage of their annual return comes from income rather than growth. Cash has an advantage over bonds of immediate liquidity, but the disadvantage of lower levels of income.
While cash tends to have higher income risk than longer-term maturity bonds, it does not face interest-rate risk. When interest rates rise, a bond’s value will drop, and the longer the maturity, the greater the drop, all other things equal. It is this characteristic of cash investments—virtually no downside risk over the short term—that makes it quite useful when combined with more risky, growth-oriented investments in an investment portfolio.
Adding cash to the portfolio mix can allow you to lower your portfolio’s downside risk, or it can allow you to increase your investment in more growth-oriented stocks without increasing your downside risk.
While increasing your stock exposure may not seem particularly appealing in the current market environment, stocks do offer the only real protection against inflation risk—the risk that your portfolio will fail to grow in real (purchasing power) terms over the long term. Investment portfolios with stock commitments below 50% face the substantial risk that the portfolio will not grow enough to sustain annual withdrawals that can keep pace with inflation throughout your retirement period.
Here are some thoughts to keep in mind when pondering the role of “risk-free” assets in your portfolio:
- There is no such thing as a truly risk-free asset for long-term investors. Treasury bills do not face credit risk or interest rate risk, but they do face inflation risk (offering virtually no growth above the rate of inflation) and income risk (the income they provide may fall sharply in a relatively short time, in tandem with declining short-term interest rates). What appears to be risk-free and stable may in fact translate into a declining amount over longer time periods if it doesn’t increase with inflation.
- Treasury bills and other cash reserves should be kept so that you are not forced to sell long-term investments at inopportune times due to unexpected emergencies or at major market downturns in which you do not want to sell stocks for an extended time period.
- A substantial commitment to stocks will most likely be needed to provide growth and prevent a loss in real terms of the value of your long-term investment portfolio. But Treasury bills and other cash investments can be used to moderate the downside risk introduced by a large stock component and investments in more aggressive stocks.