Rethinking the Risk-Free Rate: Offering Alternatives
In an earlier post, “Rethinking the Risk-Free Rate, Exploding a Fundamental Assumption,” I criticized the concept of the “risk-free rate of return” as both illogical and not reflective of reality. Although I acknowledged the logic of having a bedrock rate of return that serves as a minimum acceptable rate of return, I proposed renaming it the “lowest-available-risk expected rate of return.”
In this follow-up post I’ll offer some alternative bedrock rates of return for consideration. My preferred, for reasons explained below, is multifactor productivity growth.
First, some context: As imagined, the “risk-free” rate of return is supposed to be the rate that investors may always count on earning no matter the current state of the world. Therefore, it is supposed to be the bedrock rate of return that is the foundation of all other rates. If you are an equity investor, you begin building your required rate of return on equity using the “risk-free” rate. Likewise, if you are a buyer of fine art you are also supposed to use the “risk-free” rate as your bedrock required rate.
At a minimum, all investors, regardless of asset class, want a portfolio to earn at least the rate of the bedrock rate of return.
This suggests something fundamentally important about any possible alternative candidate for the bedrock rate of return: It must be universal. In other words, a bedrock rate of return must cut across all possible investments such that investors in commodities, art, education, real estate, businesses, equities, bonds, options, or any other asset would all view the bedrock rate of return as their starting place for crafting a required rate of return. Since each of the preceding activities is an economic activity, a bedrock required rate of return should also reflect actual economic growth, defined as getting more from the same set of resources, or getting the same from a smaller set of resources.
With that in mind here are a few alternatives.
Alternative Risk-Free Rate 1: Average Real Gross Domestic Product Growth
Gross domestic product (GDP) growth reflects the growth of the entire economy, and consequently of all of its assets. Yet inflation erodes the value of any asset whose worth is denominated by currency. Modifying GDP for the deleterious effects of inflation to arrive at real domestic product is necessary and noncontroversial. Yet even real GDP growth has a philosophical problem that limits its use as an alternative risk-free rate. Growth in the population also causes growth in the economy. But, just because there are more mouths to feed does not necessarily mean that the individuals that make up an economy have found a way of getting more from the same set of resources, or the same from a smaller set of resources. Here economic actors are just using resources up, rather than finding ways of using them more efficiently. Thus, even real GDP needs to be adjusted for population growth.
Alternative Risk-Free Rate 2: Population-Adjusted Real Gross Domestic Product
Yet even a population-adjusted real gross domestic product is problematic as a risk-free rate of return alternative. Why? Because children and the elderly are not generally economic actors. Put another way, children and the elderly, in having money spent on them or in spending their savings, do add to gross domestic product — but they do not necessarily add to actual economic growth as I have defined it. Because the elderly are more likely to contribute to actual economic growth than are children (and for the sake of simplicity), I recommend simply backing the population growth of some years prior out of real GDP growth to remove the “more mouths to feed” problem.
So how far back in time must we go when examining population growth? Most would agree that children do not begin contributing to the economy until they are around 15 years old, and most are not truly self-sufficient until around 25 years old. On average, the population growth for the preceding 15 to 25 years in the United States is 1.6%.
I dealt with this very issue in my prior writing and concluded that, in the United States, inflation-adjusted and population-adjusted economic growth had been 1.9% from 1933–2011. This was based on average GDP growth of 7.5% (1933–2011), average inflation of 3.8%, and average population growth in the preceding 15–25 years of 1.6%. [Note: The actual calculation is ((1 + 0.075) ÷ (1 + 0.038) ÷ (1 + 0.016) = 1.0193) – 1.]
Alternative Risk-Free Rate 3: Productivity Growth
The above measure is somewhat similar to productivity growth. I would argue that at a minimum, investors universally will want to capture the aggregate innovation of human ingenuity. After all, that is exactly what investing is about: Those with an excess of resources, but a deficit of innovation, seek to partner with those with a deficit of resources and an excess of innovation in order to grow the resources of both.
Yet the oft-reported productivity figure is just total output divided by the total hours worked by labor, so even this measure is incomplete. In the United States, a joint venture between the Bureau of Labor Statistics and the Bureau of Economic Advisors has created a “multifactor productivity” that seeks to be a comprehensive measure of innovation. For various 10-year rolling periods this number has averaged 1.1% for the non-farm private business sector.
Currently, the proxy for the bedrock required rate of return, constant maturity Treasuries, relies upon the strength of intelligence and character (creditworthiness) of an elected body and its monetary authorities for their performance. In other words, constant maturity Treasuries are an investment in a complex system that often reflects human frailty as much as, or more than, human virtue.
Thus one further advantage of using multifactor productivity growth as the “lowest-available-risk expected rate of return” is that unlike constant maturity Treasury securities, its performance rests on a seemingly innate, perhaps riskless quality of humanity that one can actually rely upon: The desire to make one’s life better through innovation.
If the essence of investing is about capturing the fruits of human productivity and innovation, then the bedrock required rate of return ought to be based on productivity and innovation, too.
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.