Your Risk-Free Rate

Jonathan Clements  |  December 10, 2016

WHEN DECIDING WHETHER it’s worth taking an investment risk, your starting point should be the so-called risk-free rate. That’s the return you can earn by taking little or no risk. Got your eye on an investment that might perform better? You need to decide whether the potential extra return, relative to the risk-free rate, is worth the added danger involved.

When experts talk about the risk-free rate, they usually point to some sort of Treasury security. Lately, that’s been an easy bogey to beat, thanks to the Federal Reserve’s loose monetary policy. For instance, if you have a short investment time horizon, you might compare possible investments to three-month Treasury bills, which today yield a tiny 0.5%. Longer-term investors might look to 10-year Treasury notes, which currently yield almost 2.5%, or even to 10-year inflation-indexed Treasurys, which are paying 0.6% above inflation.

But arguably, for anyone with loans outstanding, the risk-free rate shouldn’t be a Treasury security, but rather the interest rate on their highest-cost debt—and that can be a much tougher benchmark to beat. Let’s say you’re carrying a credit-card balance costing 20% a year. Paying off that balance is likely a smarter bet than any investment, except perhaps funding a 401(k) plan with a matching employer contribution.

Even tax-deductible mortgage debt can prove to be a high hurdle. Suppose you’re in the 25% tax bracket and your mortgage is costing you 4%, so your after-tax cost is 3%. You should be able to outpace that 3% over the long haul by buying stocks. But if you’re inclined to purchase bonds or certificates of deposit, you would probably be better off paying down your mortgage.

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