The standard “low risk” asset is short term treasury bills.
If you are holding investment assets to be the low-risk part of your portfolio, there is a good argument to hold the lowest risk such investment.
For US investors, the two best candidates for low-risk asset are probably T-Bills, and actual cash.
Actual Cash
The main argument in favor of actual cash is that if you hold physical cash, that cash does not have to paid to you by any other party.
However, there are three arguments that physical cash is not a good “low risk” asset from a portfolio point of view.[1] These are:
- Legal restrictions
- Risk of loss through theft or fire
- The possibility that the government will nullify the cash or change it and restrict exchange of the old for the new
T-Bills
The unsuitability of physical cash leaves T-Bills as the “riskless” asset of choice. The argument in favor of T-bills is that as direct obligations of the US government, which can if needed simply print the money to repay, the probability of a money default on T-bills is lower than the probability on any other asset.
Other Money Market Assets
There are many other assets in the money markets besides T-bills. All tend to yield slightly more than T-bills, frequently enticing various investors to hold these other assets. These other money market instruments include obligations such as bank issued Certificates of Deposit, corporate issued Commercial Paper, repurchase agreements, US Agency notes, foreign government US dollar notes, and, as I learned it, Bankers Acceptances. I supposed Bankers Acceptances still exist, though in over 30 years, which included two years of me trading money markets, I’ve never come across one.
If you examine the holdings of money market mutual funds, chances are you’ll see all of these, and perhaps some others.
Since the invention of the money market mutual fund in the 1970s, there are few if any instances of money market fund investors failing to receive their principal back. That leads many people to conclude that money market funds are riskless.
People considering what to hold as a riskless asset might want to review what happened during the global financial crisis in 2007-2008.
One thing that happened was that the market for even very high-quality commercial paper, on which there was virtually no chance of default, became illiquid.
Further, the price of non-Treasuries weakened relative to Treasuries. This means that if investors were holding non-Treasury money market instruments to be “riskless” they might have found during the crisis that those money market instruments were not “riskless’ in the sense that their price became more volatile than almost anyone anticipated.
T-Bills are not riskless, but they appear to be an excellent candidate for the least risky asset, at least when risk is viewed in the relatively short term.
If we use T-Bills for the low-risk asset, what should we use for the risky asset? We will continue our exploration of that question in a future post.
Short Term Risk ≠ Long Term Risk
In previous blogs, we’ve discussed that the “riskless” asset – whether it’s T-bills or a similar short term fixed income holding such as money market funds or other money market instruments, while quite stable in the short run, are not stable in purchasing power over the long run.
Since the end of the gold standard in 1933, the US government has caused the dollar to lose value. The government causes this value loss via a policy of deliberate inflation. According to official US government figures, this loss of purchasing power has averaged about 3.5% per year.
Risk of “Low Risk” for the Long Term
Barring societal catastrophe, such as major war or hyperinflation, a portfolio consisting of all or mainly “low risk” assets is very likely to “feel” low risk most or all of the time, because the effects of gradual inflation are felt mostly over time.
Look again at the above graph of the purchasing power of a dollar. From a glance, the purchasing power of the dollar looks pretty stable from the mid-1980s on.
However, though it’s hard to see in the graph, the dollar lost more than half its purchasing power over that period.
The flip side of that coin is that it means a portfolio would have to double over that time, just to stay even.
Put differently, if you started in, say, 1990, with $1 million, by 2020 (before the recent sharp inflation) you would have had to have had $2 million, just to be where you were in purchasing power in 1990.
This is not just a theoretical consideration. I know several investors who, in the name of “avoiding risk” kept their portfolios all or almost all in “riskless” assets such as T-bills from the late 1980s or early 1990s on. Over this multi-decade time frame, three factors combine to greatly reduce the value of the portfolio, even though the portfolio might grow in nominal terms.
These three factors are:
- Spending
- Taxes
- Inflation
Spending
Spending, obviously, reduces the value of a portfolio. However, unlike taxes and inflation, for which you get no value, you at least get (or expect to get) value in exchange for the money you spend.
According to some estimates, the average high net worth investor spends about 1/3 of his or her income. That represents a high savings rate compared to most people, but in the context of a retired person with a large portfolio, if that spending comes out of portfolio return, and the portfolio is all or mostly in “riskless” assets, that spending will be extremely detrimental to the long-run purchasing power of the portfolio.
Using the long run average return on T-bills (in the US) of 3.5%, someone who spends 1/3rd of that would have remaining 2.33% growth in the portfolio.
Taxes
But the investor doesn’t keep 2.33%, because the entire 3.5% is subject to income tax. Interest on US treasuries is subject to federal tax, but not state income tax.
Income tax rates and brackets change periodically in the US, but a conservative estimate would be that a high-net-worth person would pay 33% on marginal income.
At that rate, income taxes would cut another approximately 1.17% from the nominal 3.5% return.
After spending and taxes, then, the portfolio grew at about 1.17%.
Inflation
But that growth is not enough to keep up with inflation. As we’ve previously noted, since the end of the gold standard in 1933, inflation in the US has averaged about 3.5% per year.
If a portfolio is growing at 1.17% after spending and taxes, and the purchasing power of a dollar is falling at 3.5% a year, the purchasing power of the portfolio is falling at a rate equal to the difference, at 1.17 minus 3.5, or about a negative 2.3% per year.
At that rate, the portfolio will lose half its purchasing power in about 30 years.
“Shirtsleeves to Shirtsleeves in Three Generations”
There is an old saying “shirtsleeves to shirtsleeves in three generations.” This saying was already old in 1882, when the American economist Edward Atkinson cited it and said it was old.[2] Atkinson stated: “The power of rich men to impose riches upon their descendants beyond their grandchildren has been taken away by law.”
And that was before the income tax and the estate tax!
Today, in the US and many (but by no means all) Western countries, the imposition of death taxes makes it more challenging than ever to preserve wealth intact from one generation to the next.
Case Study in “Low Risk”
Consider the Jamisons,[3] a family we’ve consulted with. The older Mr. Jamison built a business, and sold it decades ago, paying capital gains taxes. He netted $40 million, making the family, at the time, one of the 6000 wealthiest families in the country.[4] Long before it was popular or common, he flew on private jets, hobnobbed with the rich elite, had multiple homes, threw incredibly lavish parties, and lived a “lifestyle of the rich and famous.”
His investment strategy, against the advice of professional advisors, was “low risk.” To a first approximation his investments were all in the “low risk” or “riskless” asset class.
For over thirty years, taxes, inflation, and spending ate away at the purchasing power of the family’s investment portfolio.
Then, when the older generation died off, because the Jamisons had not engaged in effective estate planning, the family faced the full burden of estate taxes. Paying a federal estate tax rate of 40% put another huge dent in the family’s wealth.
By 2025, as a result of the “low risk” investment strategy, combined with the other factors mentioned, the inflation adjusted value of the portfolio was lower than it had been 35 years previously, and the family’s ranking had dropped dramatically. From being the estimated 6000th wealthiest family in the US, the family is now about the 40,000th wealthiest.
What Research Finds
Various researchers have looked at what happens to family wealth over time. The overall finding is, as the old saying suggests, that real (adjusted for inflation and the real purchasing power of wealth, as opposed to counting nominal dollars) value of family wealth declines at about 5% to 7% per year on average.
Some estimates[5] are that 70% of families lose their wealth within two generations, and 90% lose it within three generations.
Goals
The “low risk” approach can be appropriate, depending on the goals. Mr. Jamison, for example, may not have minded that his real (inflation adjusted) and relative (i.e. compared to other wealthy people) wealth was declining for the last 35 years of his life.
Despite the real and relative decline, he and his wife always had enough to live the lifestyle they chose. They continued to own multiple homes, travel between them on a private plane, and consume as lavishly as they desired.
Though the Jamisons never said so in our hearing, they might have felt fine about the fact that they were, in effect, dissipating the great wealth that they had built during the building phase of their careers.
On the other hand, most people who attain sufficient wealth that they no longer have concern for their own financial wellbeing feel a desire to protect, preserve and grow that wealth, for their family, their heirs, and sometimes also for other causes important to them.
For people with goals beyond themselves, the “low risk” approach will generally be a mistake.
As suggested above, there are multiple reasons for wealth decline, and “low risk” investing – essentially keeping the entire portfolio in the “riskless” asset or something similar, is one of them.
We plan to return to the issue of preserving family wealth in future posts, but before we do that, we will continue with the topic of the Tangency Portfolio and defining the “Risky” portfolio.
Next steps
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[1] Physical cash may be a useful asset from a banking system malfunction point of view. That is a different discussion.
[2] “The Rapid Progress of Communism” an article in Atlantic Monthly, June, 1882.
[3] Not the actual name.
[4] We estimate the number of families at the wealth level using data from the Fed’s Survey of Consumer Finances, empirical estimates of the statistics of wealth distribution drawing on work by Emmanuel Saez (QJE, 2003), and the assumption that family wealth follows a power law distribution.
[5] E.g. Williams and Preisser, 2010
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