Investments that involve risk are superior only if the return more than fully compensates for the risk

Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk. Treasury bills are the closest thing to a riskless investment; hence the interest rate on Treasury bills is considered the risk-free rate.  Since investors always have the option of holding all of their money in T-bills, investments that involve risk should only be made if they hold the promise of considerably higher returns than those available without risk. This does not express an investment preference for T-bills; to the contrary, you would rather be fully invested in superior alternatives. But alternatives with some risk attached are superior only if the return more than fully compensates for the risk.

Most investment approaches do not focus on loss avoidance or on an assessment of the real risks of an investment compared with its return. Only one that I know does: value' investing.

Risk-free rate

VALUE INVESTING APPROACH TO RISK AND RATES

The “risk-free rate” can be estimated by reference to U.S. government securities, loans investors make to the U.S. Treasury.

The U.S. Treasury is seen as the purest credit risk in the world, committed to paying its debts when due without fail. Hence, yields on U.S. Treasury debt are considered the benchmark for valuing all other assets, including corporate debt and equities.

Corporate debt bears greater risk than U.S. Treasury debt. In corporate bankruptcy, debt is paid before common stock, so the common stock of a company carrying debt bears a greater risk than that debt.

Selecting a risk-free rate requires judgment based on various factors. Such factors include:

• bond maturity,
• reference date or time frame, and
• reference source.

Possible sources include the rate disclose in the company’s own public filings. This is a non-arbitrary choice, reflecting the rate the company uses for its internal purposes and considered sufficiently material to disclose in its public filings.

Other customs include using 30-year bonds to reflect the long-term character of the investment in a corporation.

When valuing a business as a going concern, following the daily, weekly, or monthly movements in the U.S. Treasury market introduces distorting valuation volatility into the exercise. Business value does not move in tandem with daily or even monthly fluctuations in Treasury rates. Avoiding the sensitivity to short-term fluctuations in treasury rates can be done by averaging rates over the preceding year or so.

To the risk-free is added an amount reflecting risks associated with a particular investment. This produces the discount rate to apply to determine the present value of an asset. For a business with debt and equity in its capital structure, this is commonly called the weighted average cost of capital (WACC).


Also read:

1. Understanding Discount Rates
2. Risk-free rate
3. Traditional Method: Discount rate or WACC (I)
4. Traditional Method: Discount rate or WACC (II)
5. Modern Portfolio Theory
6. Portfolio Theory: Market Risk Premiums
7. Portfolio Theory: Beta
8. Is the market efficient, always?
9. Discount Rate Determinations: Summary