Risk Free Return or Return Free Risk
Risk Free Return is such a misused term in Finance and Investing.
Just because it is labelled so, we literally believe that the Returns are Risk Free. However, when the word “Risk” is truly unpacked, the term “Risk Free Return” takes a completely new dimension. My hope is for you to understand this key distinction as this has an outsized impact on your financial life.
When the term “Risk” is used in the context of markets or in Mutual Fund Sahi Hai campaigns, it is looked at predominantly from these 2 lenses:
- Volatility (Means prices going up and down)
- Permanent Loss of Capital (PLOC)
Thus, when we hear “Risk Free Return”, what we are really hearing is:
- Volatility Free Return
- PLOC Free Return.
However, a key and dangerous element of risk is left out conveniently.
We call this monster “Inflation”, and it is clearly the biggest risk every investor faces. Since this is invisible, we tend to ignore it. Additionally, since our brains are wired to just think in terms of absolute numbers (that we invested X and we are getting Y), we price this risk out of the return completely. Price this risk out in simple terms means that we do not factor it in our Risk-Free Return Calculations.
The way I look at it is slightly different. To me, Risk Free Return is NOT Really Risk-Free Return because it just does not factor an increase in our daily living expenses (that is normally referred to as Inflation). While volatility is temporary and short term, and PLOC can be eliminated by diversifying and investing for the long term, inflation is generally permanent.
By the way, general inflation of 4-6 % that is published as Consumer Price Index (CPI) might seem low or high, but have you ever considered Lifestyle Inflation?
Lifestyle Inflation is a completely different number and is often in double digits. It is a function of the lifestyle we lead and is tailor made for every family depending on their lifestyle expenses.
Let me give you a couple of examples. The first one is my favourite example of the Tolls on the Mumbai Pune Expressway.
Look at the Mumbai Pune Expressway Toll inflation in the last 18 months -2 years. I had travelled to Pune sometime in 2019 and the toll I had paid at the main Mumbai –Pune Expressway was Rs.165. In December 2020, when I went again for a day, the toll was Rs.270.
Can you see the jump here?
It is 64%. The Toll Inflation in these 2 years was 64% and the best part that is unbelievable is that a sizable jump of this was made in 2020 during COVID-19. Commercial Tolls were up significantly too. While I know that this jump of 64 % has happened after the price of Rs.165 being held steady for a long time, the point is that such jumps have a cascading impact on goods and services in general. At a basic level, I would peg this to be somewhere in the region of 5-8%.
Take a look at Education Inflation. This number is as high as 8-12% per year at a conservative level and in specialized fields can go higher.
Finally let us look at the Dollar Inflation. The price of the dollar versus our rupee. In 2011, one dollar was Rs.46. Today it is Rs.74. The absolute inflation over the decade has been 60% but can we safely assume a base rate of 4-5% Dollar inflation here. Absolutely.
Additionally, this lifestyle inflation impacts every area such as eating out, transportation, medical services, and even something as basic as grocery shopping. I am not even getting into the subject of Asset Price Inflation (which is a different one and will cover in a Future Post).
At a very conservative level, I would peg the Lifestyle Inflation to be at least 8-10%. It will be significantly higher for different lifestyle choices with premium housing, healthcare, education, cars, and international vacations.
Some of the numbers might be open for debate like everything else is but do not waste your time on it even if you are right. The objective in the examples above was to highlight the inflation monster.
One look at the Lifestyle Inflation we all face (the real number that is way beyond the reported CPI number of inflation), you would realize that the Risk-Free Return does an even shoddier job of protecting us.
We end up losing the purchasing power of our money by investing in so-called Risk-Free Products. We end up exposing our money to Lifestyle Inflation Risk in the process of avoiding Short Term Volatility. Risk Free is as Dangerous as the words Free and Guarantee. It is no Wonder that the word Risk Free has embedded in its core, the 2 dangerous words Free and Guarantee.
A wise way to look at Risk Free Return should be as follows: “Volatility Free & Illusionary Capital Protection” Return with no Protection against Lifestyle Inflation.
I have taken a shot at a couple of interesting equations:
Risk Free Return = Volatility Free Low Return with Hidden and Loaded Inflation Risk
Or may I say Risk Free Return = “Return Free Risk”
Think about it – Risk Free Return or Return Free Risk
What do you think?
To Be Continued.