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The Illusion of Safety and Your Portfolio

This site writes a lot about the need to take and mitigate risk.  But today I want to focus on the opposite.    Particularly I want to focus on what is known in the investment world as the flight to safety.  In doing so we will explore the nature of risk and the illusion of safety and security.

Defining the Flight to Safety

So what is the flight to safety?  Well, most commonly this term is used in an article during a market correction.  It is also frequently used when a correction is foretold by the media, whether it happens or not.  The general premise is an investor will move from riskier to less risky investments in a volatile market.   In this way they will seek to preserve capital, ie. trade future return for less risk in losing the money they already have.

Forms of Flight to Safety

This flight to safety, depending on the article, is said to take many forms.   When we are talking about volatile tech stocks the writer might speak of switching to companies less inclined to major swings in price.  Utilities are common example used as synonyms for less risky stock.  But is it really safer?

Utilities

Well, normally utilities don’t swing in price quickly.  As an industry there are high barriers to competition.  Also, they have a relatively captive audience.  Finally, the demand for their product does not change much based on the economy.  Ie. few people are turning the TV off or the thermostat down just because there is a recession.  So on the face of it they are fairly stable.  Their normal price moves reflect that stability.  A 5% regular day move for a utility would be considered beyond the normal.

But the safety of the utility stock based on normal volatility is a bit of an illusion.  You see many utilities can’t set their prices to end consumers.  Those prices are regulated and adjusting them requires approval from their state regulatory body.      These companies also tend to carry high debt loads as they are a capital intensive business.  So a change in costs of items to the utility, say from inflation, can really impact their returns.  Thus interest rate swings can shatter the illusion of safety of utility stocks.    

Note: the above example is a fairly common event.  Utilities can also swing from major events like legal liability from forest fires or exploding power plants.   The point here is not to shoot down utilities but instead to point out there are still risks.

Treasury Bills

Which brings us to the next flight to safety option often cited, moving to Treasury Bills.  In business school, they define the rate of return of treasury bills as the risk-free rate.  The idea is that the government is the least likely entity in the economy to go broke since they can print money.  So essentially the government must have the highest credit rating in a country.  Thus they should get the lowest risk-adjusted rate.   

All the above is true.  But treasury’s are not without risk.   First, there is our friend inflation again.  If a treasury doesn’t return enough it will erode in value once inflation exceeds the return. Do you believe that inflation will never be larger than the interest rate or that inflation always declines?  Well, you’d be wrong.

A Brief History of Inflation  

I have no crystal ball to predict the future.  But I can point out that inflation and interest rates were in the double digits in the late 70s. The percent inflation in the 60s was actually lower than it is today.  

If you were to buy a 10-year treasury at today’s rates how much would you lose if inflation jumped to 13.5% like in 1980?    Well, a 10-year treasury would have 9.1 as the duration.  That means for each 1% change in interest rates the value of that treasury would decline 9.1%.    So a 10 percent rise in interest rates would eat up 91% of the value of your new bond.. Yipes!

Lest you think I am cherry-picking the data to make my argument you should check out this inflation history site

You will find that 1980 is not the only double-digit inflation year.  You will also find more than 1 year with swings of 4, 6, and even 10 percent.    So we can establish that a treasury has risk, even if you don’t think a massive interest spike is likely any time soon.

Cash

What about cash?  Well, the value of the cash in your pocket measured in your local currency doesn’t change with the economy.  But inflation by it’s definition is a change in the purchasing power of your cash.  So inflation means you can buy less with your money, essentially a risk to holding cash.  So again we see there is an illusion of safety.

That of course also ignores counterparty risk or the risk of theft.  You have to keep your funds somewhere.  Under your bed someone could steal it.  I was reading recently about negative interest rates in Europe.  The question was why do people not keep their assets in cash rather than pay to loan money.  Well, the answer is most likely because keeping a large amount of cash on you is a recipe to get robbed.   Life and limb is a level of risk well beyond a few bucks in negative interest rates. 

Bank Deposit Risks

Even in a bank, there is still some level of counterparty risk.  The government insurance fund FDIC insures your deposits in case a bank goes bankrupt.  But what would happen if the fund was overwhelmed by too many claims?    The FDIC is currently funded by fees on member insitutions.  But it is entirely possible someday the number of claims could exceed the funds.  Would the government, or even could they if things were dire enough, bail out the FDIC… It’s interesting to contemplate.  

No such thing as Risk-free, But There Is Such a Thing as Safer

But this last example also might be a bit extreme in analyzing risk. Which brings me back to the illusion of safety and security.  Everything above can establish there is no such thing as a risk-free investment.  In fact, there is no such thing as a risk-free action in life.  Your next step could trigger a chain reaction that could cause your death…  You could take two steps to the left and get hit by a meteor.

But the likelihood of your next step leading you under a meteor is about as high as winning the lottery.  IE statistically near 0 except in certain specific cases.  As we’ve discussed before you should mitigate risks based on the likelihood and severity.   Our FDIC failure example is possible, but it hasn’t happened since it’s founding in 1933.  IE it’s probably not something you should lay awake worrying about as odds are it will never happen.  If it did we’d all likely have bigger issues.

Safety Is An Illusion

Which brings us really to the point.  There is no such thing as a fully safe investment.  Safety is an illusion.  But there is such a thing as a less risky or less likely to wipe you out investment.    The key is to understand which risks you are taking in any investment.  Then you need to determine how likely and how bad a negative event is.  Then and only then can you decide if you should invest.   

Don’t Invest In Things You Don’t Understand

You should never invest in something you don’t understand.  If you can’t understand it then you can’t understand it’s risk.  That means you can’t make an adequate decision on whether the possible upside compensates you for this risk.  You also cannot explore ways to mitigate those risks on your overall financial health.    Finally, you can’t even be sure the investment is real and not just some sort of stock market scam.  Always do your diligence.. Be safe out there!

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