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A purchase of a new sports car is many things: expensive, impractical, fun and, potentially, an indication of the attainment of a certain age.  Those purchasers who require a payment plan have little choice in the inevitable call to the insurance company to obtain the similarly expensive comprehensive and collision coverage.  Those able to buy the sports car in cash have an entirely different dilemma – pay for that expensive package of insurance, or scrimp and go only with the mandated liability coverage.

This isn’t much of a decision, even for the cash buyer, as the potential loss of $50k or more should the vehicle be stolen or wrecked (people don’t buy sports cars to go the speed limit) far outweighs the extra money required to insure it.  There likely are some folks, however, who decide to forego the extra coverage and hope for the best.  The merits of that decision are dubious, but the buyer had the ability to make a risk/return decision and, in this case, chose risk.

The world of investing has long been governed by this theme of risk and return.  Those who want or need higher returns invest in equities, while those who are willing to sacrifice return in favor of stability choose fixed income.  Finally, those who value preservation of capital as the highest, most important, goal choose instruments such as CDs and money market accounts.  This last category sacrifices the majority of the upside for the notion that there is no downside (at least for those who ignore the impact of inflation). 

The notion of a risk-free rate of return is pervasive, and several calculations used in modern portfolio theory rely upon that factor.  As a practical matter, the rate on the 3-month Treasury bill is the proxy for the risk-free rate of return.  Historically, there was little argument with the choice of the 3-month T-bill as it represents an ultra-short term loan to the largest economy in the world -- which also happens to sponsor the world’s reserve currency.

Several not-so-funny things have happened to that same economy in the past few years: the bursting of the residential real estate bubble, the corresponding free-fall in the equity markets, the breaking of the buck within the money market realm, record unemployment, a sputtering GDP and, of course, the downgrade of long-term debt.  With all of those events in mind, it would be logical to assume that the price of the 3 month T-bill had suffered.  Many investment management firms made that exact bet, and lost, as the price of all Treasuries has soared with the corresponding rates dropping to the point where there is little, if any, yield.

Those who continue to seek risk in the investing world have no shortage of vehicles from which to choose.  Risk is not something that is hard to find, and there will always be risk-takers.    

The trouble is at the other end of the spectrum, where the most conservative investors (many of whom just sold their sports car at a huge loss) find that their dealers have no inventory.  Money market funds currently pay next to nothing, as do all but the longest-term CDs.  Those seeking to purchase Treasuries find that even a 3-year (year, not month) T-note pays a current yield of roughly .30%. 

There is, therefore, little return to find in the risk-free world.  There is also quite a bit more risk than was perceived in the good old days (2007 sounds like a nice place to visit – as long as you rent).  Money market funds are currently waiving or deferring part of their management fees to maintain their net asset value.  Bank failures, while slowing, continue at a disturbing rate.  Participants in 401(k) plans have seen a number of large stable value providers liquidate their pools.  Plan sponsors in the market for a new stable value fund find that inventory is extremely limited (most wrap insurers continue their refusal to write new coverage, while also posturing for a 24-month put -- up from 12 – and even tighter equity wash provisions).

We can’t undo the damage that has been done, but we can hope to mitigate it going forward.  We should realign our perspective and our expectations.  While it was convenient to label the 3-month T-bill as the risk free rate of return, our current reality is that any return that can actually compound into a bigger number in the next 20 years is going to require risk.  Table 1 shows the more recent performance for investment categories typically held out to be amongst the safer options:

Table 1*

You will likely notice that gold was included as an option, and there is no doubt that it has had a meteoric rise over the past few years.  What was the return landscape like for these options before/during the last significant crash?  Please see Table 2.

Table 2*

Interestingly, the spectacular (and at the time, unprecedented in the modern era) crash in the equity markets in early 2000 had what many would consider to be a more normal impact on safe haven investments.  Gold was the outlier, and its performance over the period displayed in Table 2 would have removed it from safe haven discussions during that time.

What about the overall returns for these various investments over roughly the past 30 years (January 1980 thru August of 2011)?  A view (Table 3) over this type of extended period reveals why many have been comfortable considering instruments such as the 3-month T bill as risk free.  It also reinforces why many, for better or worse, do not consider gold to be a safe haven.

Table 3*

It is always useful to know what has happened in the past (or be doomed to repeat it).  It is also good to remember that, in the world of investing, things can stay the same until they don’t.  “This time is different,” is an over-used, often incorrect statement.  Our current environment, however, might truly be different.  The most recent crash exposed the extremely weak, borderline fraudulent underpinnings of the majority of the world’s largest financial institutions.  The prior crash in 2000 was significant but was more confined to the dot-com, technology realm. 

Here are some harsh realities regarding the selection of investment vehicles in our 2011 inventory:

• Those content to remain in money markets and CDs should embrace the fact that they aren’t going anywhere fast – it might actually be easier to get out and walk.  The Fed’s pledge to maintain low rates through 2013 is added incentive to explore other options.
• Stable value investors must understand that these funds are, at their core, bond funds.  While stable value funds go to great lengths to mitigate potential losses, the overall health of the bond market does play a key role in the current crediting rate and the overall health of the stable value industry.  
• Bond market investors should prepare for the fact that Treasuries, like RPMs, can’t go up forever – can they?
• Investors in precious metals should congratulate themselves if they made their purchases several years ago, and start worrying about the trade in value of something that’s currently near its all time high. 
• Those in the stock market need to understand that 0-60 performance on a closed track don’t mean much when the actual roads are laden with pot holes and boulders.
• And, finally, those of us who consider ourselves professional drivers on the investment track may need to change up the tools in our pit crew – particularly in regard to statistics that rely upon a risk free rate of return.

With all of that being said, a life without risk is likely not very rewarding – and risk is no longer something that you can attempt to avoid.

Marshall J. Cobb, CRSP, is president and founder of Cobb Retirement Solutions, LLC., an independent, fee-only firm offering qualified plan analysis and oversight exclusively to corporations and organizations. Cobb’s first-hand knowledge as a veteran representative of retirement plan vendors beginning in 1990 gives him a unique perspective as he advises his clients.  Cobb runs his office -- based in Houston, Texas -- with employees and clients across the country.

*The performance data quoted herein represents past performance.  Past performance does not guarantee future results.  Current performance may be lower or higher than the performance data quoted.  Neither the information presented nor any opinion expressed constitutes a representation by us or a solicitation of the purchase or sale of any securities.  Cobb Retirement Solutions, LLC utilized Zephyr StyleADVISOR to produce the preceding information.  All data is as of August 31, 2011 unless otherwise stated.