"The Yield Curve is God"

I'll never forget that phrase, uttered at a Financial Planning Association luncheon presentation by Jeanett Garretty of Wells Fargo Private Bank. She was reminding us that risk-free interest rates are defined by the Yield Curve - the interest rates for US Treasury securites of different durations. Any investment with a rate of return above the Yield Curve contains risk. The amount of risk is related to the difference between the rate offered and the risk-free rate.

I mention this because of ads I see in our local paper (copied below) claiming a 10% annual return based on a 6 month investment. The risk-free rate for a 6 month investment as I write this is 1.91%. That's 8% less than the ad offers. Does this mean that we have found a good place to put our money?

Let's review the concept of arbitrage: the practice of taking advantage of a price differential between two or more markets, or when two assets with identical cash flows trade at different prices. It appears we could borrow money at 1.91%, use it to buy the investment that gives us 10%, and pocket the difference as profit. How come those clever traders on Wall Street didn't think of this? Well, they know enough to figure the risk involved. My point is that a 10% return, or a 7% return, or whatever, are meaningless numbers unless you can also judge the associated risk. I'm not saying this is a bad investment, only that we are seeing just half of the story in this ad.

Where do you get the risk number so you can really evaluate the investment? There's the rub - there is no easy or standardized measure of risk. You should start with the variability of the return demonstrated by the investment in the past (its standard deviation). The variability must always be understood in the context of the long term rate of return obtained from the investment. The best comparison for investments of differing rates of return and variability is the Coefficient of Variation, calculated by dividing the standard deviation by the average rate or return for each investment, then selecting the investment that gives the lowest number. Remember, these statistical measures are based on past history and cannot predict what the risk will be in future market conditions, for example in today's market affected by the credit crunch. That is why you so often see the disclaimer 'Past performance is no guarantee of future results' and why you won't find a risk measurement for a stock on the popular financial web sties..

My final point about risk is that it is not like a knob. Turning up the risk doesn't necessarily mean you will get a higher return from your investment. Sometimes all you get is more risk!

Right now, the markets are down and people have been reminded of the risk inherent in seeking higher returns. Is this the time for you to seek professional help with your investments? If so, call us at (408) 725-7135

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