Ernest Hemingway (Wikimedia)
Back in 2005, my college Biology professor, Wade Powell, turned back a written assignment to me with a terse critique: More Hemingway, Less Faulkner.
You may recognize the quote, or maybe the idea.
Ernest Hemingway and William Faulkner were, without question, great American writers. Faulkner had a reputation for writing long, complex, ornate sentences – his longest, in Absalom, Absalom!, was 1,288 words – which, granted, was an outlier, but he had a penchant for going-on about things.
Hemingway didn't. Sentences were short and to the point. His language was simple.
The iceberg analogy, which you may have seen business and planning strategists use to describe the small amount that customers see (above the water), versus the much larger, critical foundation (below the water, that they don't see), was actually Hemingway's invention that he used to describe his own literary technique.
In his words:
If a writer of prose knows enough about what he is writing about, he may omit things that he knows and the reader, if the writer is writing truly enough, will have a feeling of those things as strongly as though the writer had stated them.
The dignity of movement of the iceberg is due to only one-eighth of it being above water.
Faulkner won the Nobel Prize in Literature in 1949, and Hemingway did the same in 1954. Clearly, in narrative fiction, writing like either Hemingway or Faulkner can work well.
But for communicating investing concepts, Professor Powell's advice objectively wins. More Hemingway.
Furthermore, one might ask, what part of the iceberg should everyday investors take the time to understand, and which parts can they skip?
If there's one investment concept that is easily observable (above the waterline), and reflects much of what is going on below the waterline in financial markets, it's obvious: the risk-free rate.
The risk-free rate is the starting block for all investing, and it's intuitive why: if there is a rate of return we can get risklessly, why accept any rate below that? Like life, we only want to pursue additional risks if they are accompanied by additional expected rewards.
It's even more important as an investor in 2022. Here's why.
Opportunity costs are everywhere in life. You can't go to this social event if you want to instead go to that social event at the same time. One comes at the expense of the other.
If you only have enough money to buy either a new TV or a new bicycle, similarly, choosing one is at the cost of the other. If you are exploring buying stocks, the opportunity cost is what you could otherwise do with your money...maybe that's another investment decision like buying bonds or Bitcoin, but maybe it's just buying a TV, a purse, or a plane ticket to visit an old friend.
Opportunity costs are broadly defined, and unique to what each person could otherwise do with the money.
But the risk-free rate is a very narrowly defined opportunity cost, and is the same for everyone: the risk-free rate measures the riskless opportunity cost of a purchase or investment.
It asks, what is the return on a zero-risk investment, instead?
It's the perfect starting place to benchmark any purchase decision, and it's framed in reference to your expected holding period.
Most of us are familiar with riskless investments because we have a bank account. Broadly speaking, the savings yields we get from trustworthy banks are typically considered somewhat riskless, albeit the returns are paltry.
What the bank offers is positioned as a risk-free rate, but it is not THE risk-free rate.
The risk-free rate is knowable and universal: it's currently 3.07% for one-year.
The risk-free rate is the yield on a U.S. treasury bill of the same maturity as your investment horizon.
U.S. treasury bills are backed by the full faith and credit of the U.S. government, and considered riskless to investors across the world. In theory, our mindsets should work a bit like this:
Should I own stocks or corporate bonds (and their accompanying risks) given that I could instead invest with zero-risk, and guarantee myself 3.07%?
Should I buy this purse/t-shirt/TV/plane ticket, which I may potentially regret doing in a year...or should I just guarantee myself an increase of 3.07% over that time?
It's an incredibly practical concept for decision-makers, and a great reminder to not consider your alternatives as just nothing. The alternative is at least the risk-free rate.
Because the alternative being just nothing...well, that's so last year – when the risk-free rate was 0.07%! That is basically nothing! On $10,000, that's just $7 per year. You basically had no riskless opportunity cost to any purchase.
But today's 3.07% risk-free rate is 4,386% higher than that.
And so, ala Hemingway, here are 4 simple takeaways to manage a world of higher risk-free rates.
1. Your opportunity costs have gone up.
Since you can now guarantee yourself meaningfully more riskless return, there is a better option against all potential purchases. All else equal, it should feel harder to buy t-shirts, purses, plane tickets, etc. compared to last year.
2. The risk-free rate is the starting point for any risk and reward comparison.
While it should be harder to justify consumer purchases, it should be easier to justify prudently investing more. This is hard for folks spooked by the economy and financial markets right now, but stocks and bonds must have higher expected returns than the relevant risk-free rate. Investors wouldn't take the additional risks of stocks and bonds without expecting additional return, and current prices reflect the average opinions of investors.
3. Your bank is earning more on your money, but not necessarily giving it to you.
Most competitive banks are only giving customers 1.0%-1.5% annual yields in savings accounts, yet you only want to pursue returns higher than 3.07%. There are good logistical reasons to accept lower returns, like the fact that keeping money in the bank is useful to pay bills, get cash, etc...but in 2022 you can now get more return for the same risk elsewhere. So at least be wary of keeping too much cash in your bank account, unless you're getting a high yield rate competitive with the risk-free rate. Wasn't really an issue last year, but it's an issue now.
4. Riskless and near-riskless investments can help fight inflation.
Last year at this time, inflation was ~ 5%, and the risk free rate was 0.07%. You couldn't control the 5%, and it eroded the purchasing power of your dollars. You had to take risks, like by owning stocks or bonds or real estate, to meaningfully try and fight it.
Today, inflation is ~ 9% and the risk-free rate is 3.07%. You can't control the 9%, and it's eroding the purchasing power of your dollars even faster. You can take risks, like by owning stocks and bonds or real estate, to meaningfully try and fight it. Another option is to at least claw back over 3% without taking any risk.
In biographer A.E Hotchner's personal memoir about his friendship with Ernest Hemingway, Papa Hemingway, he quotes a story that Ernest told him:
One time my son Patrick brought me a story and asked me to edit it for him. I went over it carefully and changed one word. "But, Papa," Mousy said, "you've only changed one word."
I said, "If it's the right word, that's a lot."
The investment landscape has had some once-in-a-generation shifts recently. The change in the risk-free rate is one of them, and from what I can tell a seemingly overlooked one, but one that's not hard to understand.
More guaranteed return now, for the same risk as then.
0.07% to 3.07% in just one year. A 4,386% increase.
Just one change, but it's one of those changes that changes everything.