No Place to Hide: Investing in a World With No Risk-Free Asset

Now, more than perhaps at any time in the past 70 years, investors are concerned that there's no asset they can invest in which is truly risk-free. Worries of unsustainable public policies leading to debasement or default – through inflation, taxation or repudiation – have sapped confidence in the traditional safe assets of bills and bonds issued by the US and other rich countries. Investors are increasingly considering whether other assets – equities, real estate, commodities, crypto-currencies – should be used to construct an ersatz risk-free asset. In this note, we'll address this problem with a practical definition of the ideal personalized risk-free asset, and then we'll discuss how to construct an efficient portfolio when that ideal asset doesn't exist in investable form. Rather than the common practice of trying to construct a pseudo-risk-free asset from a set of available assets which don't really fit the bill, instead we should simply treat the opportunity set as consisting entirely of risky assets and optimize the real risk-adjusted return of the risky portfolio, using our personalized inflation index as the deflator. In practice, this approach to portfolio construction in the absence of a truly risk-free asset is flexible enough to handle an arbitrarily large number of different assets and a broad range of assumptions about possible outcomes in asset prices, including discontinuous jumps as well as changing risk and correlation patterns over time. The impact of this change in perspective will depend largely on the starting point of the investor's asset allocation. For investors with low to moderate risk-aversion– who start off with a high allocation to equities and other patently risky assets– treating the safest assets as being risky, but still the least risky of the available options, is likely to have a modest impact on optimal portfolio weights. But for investors who exhibit a high level of risk-aversion, who are mostly allocated to the safest assets to begin with, explicitly accounting for the risk in government bills and bonds can have a significant impact on their asset allocation. And for almost all investors, regardless of their degree of risk-aversion, moving to an Ideal Risk-Free Asset more closely aligned with per capita income growth will reduce the investor's risk-adjusted real return and thereby call for a lower long-term spending policy.