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Risk of no return

22 Nov 2016 By Edward Hadas

Donald Trump is not an intellectual in his investments or his political views. It’s safe to say that the U.S. president-elect’s business decisions were guided by intuition more than by financial theory. The fears and doubts created by Trump’s election success, though, might prompt a much-needed change in a structurally unsound and economically dangerous academic model of reality.

The model in question is the Capital Asset Pricing Model (CAPM). Some variation of this approach is widely used by corporate and financial investors. It relies on dividing the expected return from any investment into two parts: the risk-free portion and the additional return that compensates for the risk of losses.

There are many problems with this split. One of the biggest is that the risk-free return is not so much hypothetical as mythical, since the future is always a closed book. No investment can be entirely certain.

Yet the theory assumes that some assets – or combination of assets – can in practice be protected from all turns of fortune. This has led investors to believe they can find total safety when they are frightened. Governments have responded to this expectation by supplying assets which are supposed to qualify as safe. They have issued vast quantities of short-term debt and smaller quantities of longer-term debt which is supposedly protected from the uncertainty of inflation.

Even before Trump introduced a new dimension of fear and confusion, reality had repeatedly challenged financial engineering. Governments can become less trustworthy, the value of currencies can rise or fall and official measures of inflation may be misleading. U.S. Treasury bonds, which are traditionally used as the risk-free asset in CAPM-based portfolio construction, are no exception.

The lack of truly risk-free assets is not an economic problem. Uncertain projects include not only Trump Tower and the property developer’s other luxury apartment buildings, but also the activities of governments seeking funds to supplement tax revenues.

However, the risk-free myth leads many investors to think otherwise. They assume there should be a safe way to earn a decent return in bad as well as good economic times. The attempt to keep up the illusion leads to economic problems.

When actual returns on real investments are low or negative, protected gains on supposedly risk-free paper reduce the funds available for other investors. This means that in bad times holders of risky assets suffer losses greater than if everyone had accepted a reasonable degree of risk. In good times, these investors expect higher returns from risky assets than they otherwise would. In other words, the effort to label some assets as risk-free increases the volatility of returns on everything else.

This prejudice has distorted the financial world. CAPM leads investors to expect reasonably high returns at all times, including excellent gains when the economy is flourishing. If markets oblige, then investors – who are mostly well-off to start with – end up doing extremely well. That increases economic inequality. But when markets fail to meet investors’ CAPM-driven demands, the scramble for yield can spark a growth-killing financial crisis.

Arguably, CAPM has also hurt investments in the real economy. Because lenders and investors have unrealistically high expectations for assets perceived as risky, it is difficult to get outside funding for sensible investments which are unlikely to offer more than modest returns. In this way, the risk-free illusion can hold back economic growth.

Despite the theoretical and practical problems, the mirage has held up for decades. Unexpected inflation did not destroy it. Neither did surprise disinflation or dramatic shifts in currency values. One reason for this persistence might be that investors are reluctant to abandon a theory which justifies very high returns.

A less selfish explanation is historical. The theory was developed in the United States, and it stood up as long as the country and its official debt were considered fundamentally safe and sound. That confidence has been declining for some time, due to the deadlocked American government and the rise of China. However, the dollar has remained the world’s reference currency, and U.S. sovereign debt has kept enough of its risk-free reputation to distract investors from the ridiculous intellectual underpinnings of CAPM.

Trump could change that. If he stays true to the internationally isolationist and domestically expansive spirit of his campaign, global investors’ trust in the U.S. government is likely to plummet. Trump-style political upheavals could spread to Europe, perhaps destroying the euro zone and leading to a messy Brexit. Friction with China might create economic and military troubles.

In short, the inconvenient truth that nothing in the investment world is really safe could become unavoidable. Investors could be forced to follow Trump’s approach – rely on intuition and accept risks. Though that would be disruptive and painful, it would ultimately be no bad thing. The demise of financial theory might even be a small silver lining to the cloud of difficulties caused by the shattering of an old world order.


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