The difference between 
Risk free and the market is 
Called Risk Premium.

One of the hardest issues to address for risk-averse investors is the importance of investing in the stock market. Someone can take zero risk and keep their money safe and sound in a bank deposit account. There, it will be protected, up to $250,000 by FDIC insurance and available to be withdrawn whenever the person chooses. It doesn’t get any safer than that.

Except…

Going full tilt towards safety and liquidity means that a price must be paid somewhere. A recent Fiku discussed the “Pick Two” framework: you can have safety, liquidity, or growth: pick two. If there is zero chance of loss and you have maximum liquidity in an instrument – in this case a bank savings account – you can expect little to no growth in the account.

The lack of growth potential represents its own risk in the form of lost purchasing power over time. Inflation, which has been a hot topic ever since the start of 2021, has averaged about 3.5% since World War II. That figure includes the double digit inflation of the late 70s and early 80s. Looking only at the last forty years, inflation has lived primarily in the 2-3% range.

Assuming a 3% average rate of inflation means that the cost of everything you want to buy is increasing and compounding every year, on average, around 3%. Meanwhile, a perfectly safe and liquid savings account might have interest, if you’re lucky, in the 1% range. This means that you are losing 2% of your purchasing power, year over year.

Assuming a portfolio value of $1,000,000, 2% compounded inflation every year means that in 10 years, assuming no growth of assets, $1,000,000 can now buy $817,072 worth of stuff. That’s a equivalent to a 10 year loss of 18.29%. By playing it completely safe, an investor would generate a 10 year loss of buying power exceeding the kind of loss that could get a fund manager fired.

This is why William Bengen’s 4% rule favored a stock allocation between 60-75% of the total portfolio. The 4% Rule was designed to answer the question “how much do I need to save for retirement?” along with “how much can I withdraw from my portfolio in retirement without running out of money?” Part of the rule involves adjusting that 4% for inflation every year.

Risk averse investors will not be surprised to learn that, in Bengen’s research, an allocation of stocks greater than 75% of a retirement income portfolio can be over-exposed to market corrections and reduce the longevity of the portfolio.

Risk tolerant investors will not be surprised to learn that, also in Bengen’s research, an allocation less than 60% towards stocks prevented the portfolio from consistently outperforming inflation and also reduced the longevity of the portfolio. Thanks to inflation, playing things too safe can be just as risky as taking too much risk.

The value that stocks – which carry the risk of losing value during a market correction – can bring to a portfolio is expressed in the idea of Risk Premium. Risk Premium is a metric describing how much extra growth one investment may have relative to a risk free investment.

The expected return from a completely safe investment – called the Risk Free Rate – can be subtracted from the return you can expect from a risky investment. The result is the premium you can potentially earn over time by investing in the risky investment.

In the same way that a certain rate of interest represents compensation for the risk of lending someone money, Risk Premium can be seen as the rate of compensation for risking money in the stock market.

While a bank savings account might seem like the logical choice for a risk free rate of return, what investors typically use instead is the 3 Month Treasury, or T-Bill. Since Treasuries are backed by the full faith and credit of the United States, they require no FDIC insurance. They are generally considered the safest investments in the world.

Back on June 15th, 2018, the 3 Month Treasury was yielding 1.94%. Inflation at that time was 2.9%. This means that investors would be required to take some market risks with their money – at least riskier than a Three Month T-Bill – if they hoped to keep up with inflation.

Meanwhile, the 15 year average rate of return for the Russell 3000 Index, which tracks the entire stock market, is 10.14%. Unfortunately, I have no way of calculating average returns of the index up to June 15, 2018, but it’s safe to assume the numbers would be similar.

This means that as of 6/15/2018, the Risk Premium for investing in a total market index fund would have been 8.2%, against an inflation rate of 2.9% and a Risk Free Rate of 1.94%.

The Risk Premium on the stock market in 2018 may have been far greater than what a person might expect to owe in interest on a home or auto loan. It might even have been greater than the interest on someone’s student loans.

This means that, over time, a stock investment in 2018 might make more mathematical sense than an extra loan principal payment, and that an investor may want to consider committing a heavier allocation to stocks vs. bonds. An investor could even think about taking that extra principal payment and investing it in the market instead.

But what about June 2023, which has a current rate of inflation, according to the Consumer Price Index, of 4%?

The three month Treasury now has a yield of 5.4%. This means an investor could hold the safest investment in the world and outpace inflation. Meanwhile, assuming our 15 year average total return on the Russell 3000 index of 10.14%, our Risk Premium has fallen from 8.2% in June 2018 to only 4.74% in June 2023. The Risk Premium for investing in the market right now is actually less than the yield on a 3 Month Treasury. Interesting times.

For investors, this creates a dilemma. High interest rates and market contractions typically correlate. High interest rates represent tight money policy from the Fed. This means less money circulating the economy. Companies have to pay higher interest rates to finance operations, and investors have higher interest payments on loans and, therefore, less money to invest in the market.

But investing in the market when prices are at a trough in the economic cycle is considered the investing bullseye. If market prices are off their highs, and interest rates are high, “Buy low, sell high” means investing money in the market when Risk Premium may be well below its historic averages.

This is where individual values and goals are most meaningful when it comes to portfolio design. If an investor prefers to have more money allocated to low-risk investments, now is a great time to do so. Risk Premium is low, Risk Free rates are high, and uncertainty abounds in the market.

But if someone wants to shift a portfolio into a heavier stock allocation, now is an excellent time to do that, too. Stocks have yet to fully recover from the 2022 bear market and 2023 banking crisis. The S&P 500 is still about 7.2% below its December 2021 high price of 4,422.99.

The correct allocation of a portfolio depends entirely on the investor. What is her stage of life? When will she need to make portfolio withdrawals? Are there any big expenses coming up in the near future? How much money does she need to have immediately available for emergencies? How much needs to be invested in the market to prevent loss of purchasing power over time? How much risk can she take before needing prescription strength antacids?

It is rare for the Risk Free Rate to outpace inflation while, at the same time, the Three Month Treasury yield outpaces the 15 year average Risk Premium of a total market index fund. These circumstances demand careful consideration of financial decisions. If you aren’t sure how much of your portfolio you should invest in the market and are concerned about protecting both principal and your long term purchasing power, we would love to speak with you.

At SeaCure, we have curated a suite of tools that help us make evidence-based, data-driven recommendations. Our back office of CFP®s, CPAs, insurance experts, and estate attorneys can help educate you about your options and analyze potential outcomes prior to committing to a decision. It brings us a lot of happiness to see someone’s financial confidence bloom throughout our planning process. If you’d like to experience this for yourself, please reach out.