Understood, and is probably somewhat subjective and depends on individual circumstances. One could argue that lower risk-free rates, if they were lower, should not entice people to take more risk (to the extent that one considers unleveraged equities to be risky in the long run, which is a complex topic in and by itself), but rather to work harder or longer or to reduce consumption (perceived needs, lol). If one were to rigorously solve the mathematical utility optimization problem, the solution would probably lie somewhere in between the extremes.With 10YR+ TIPS offering 2% real right now, we can actually meet our retirement needs without equities at all.
I hear what you are saying; but how exactly do lower or higher risk-free real returns affect asset allocation? Certainly +2% makes it easier to grow assets than -1%; but you could argue that risk-free rates are what they are; the individual investor cannot control them. If they were -1% and expected to stay that way for the next 30 years, which was the narrative in 2021 with many logical explanations, investors couldn't do anything about it; they would just have to work harder for the same lifestyle. You could decide to take more risk and shift to equities; but risk premia spreads are based on risk-free rates, so it's not clear that one should take more risk solely because risk-free rates are abysmally low. In 2021 you could have just attempted market timing and speculated that rates will mean-revert in some way, which would have meant attempting interest rate predictions that were different from that of the market, which we can argue forever if that was "obvious" in 2021, but which is generally a risky business. So to make the current level of rates actionable, you would have to make assumptions on mean reversion and bet against the market; then the next question is what is what is the new equilibrium level in the future. The 2% is still close to the low end compared to historical averages. You see where this is going.
I'm crossing this out because I think you said the same thing before. The ERP relative to risk-free rates is what matters.
I'm not sure if the level of the risk-free rate affects the amount of equity risk that an investor should take, or if the latter should only depend on the equity risk premium. One could argue that if you can achieve your target wealth purely with risk-free investments, you might forfeit the possibility of taking advantage of the ERP; but you could also argue that you would still try to earn the ERP and achieve your target wealth with less work and/or increase your consumption or financial freedom. I guess this is subjective.
Our risk portfolio in equities is for additional discretionary upside spending / diversification.
So, yes, in our case, the level of the risk-free rate vs ERP definitely affects the amount of equity risk we're enticed to take.
Statistics: Posted by comeinvest — Wed Oct 30, 2024 12:21 am — Replies 130 — Views 11368