One sales pitch I see tossed around a lot these days is “You should buy this stock/bond because of how much more income it pays over a risk free rate of return such as the 10-Year Treasury Bond (currently 1.87%) or a 6 Month CD (currently 0.48%).”
I find this pitch to be accurate yet extremely misleading and here’s why:
- Just because one investment pays a higher yield or income than another one doesn’t mean it is better. Income is just one part of my total return formula.
- Total Return = Gains + Income – Fees – Losses
- Nothing is risk free. A 10 year government bond may not carry the risk of the company going bankrupt but it has other risks such as inflation risk (you will be paid back tomorrow for essentially cents on the dollar).
- Choosing where to invest your money is really an exercise in choosing the types of risk(s) you are most comfortable with.
- What a 6 Month CD or other “risk free” investment returns may be substantially lower than YOUR “risk free” rate of return. If you are carrying credit card debt or any other debt for that matter your “risk free” rate of return is the interest rate you are being charged on that debt.
- According to CreditCards.com the average credit card interest rate is now 14.93%.
- Put another way, if you are the average credit card holder, you will earn a “risk free” rate of return of 14.93% simply by paying down your credit card bills.
What is your “risk free” rate of return?
What type of risks are your comfortable with?