Risk-Free Bonds Aren’t

I’ve always been an­noyed by the term “risk-free bonds rate”, mean­ing the re­turn on US Trea­sury bills. Just be­cause US bonds have not de­faulted within their trad­ing ex­pe­rience, peo­ple as­sume this is im­pos­si­ble? A list of ma­jor gov­ern­ments in 1900 would prob­a­bly put the Ot­toman Em­pire or Aus­tria-Hun­gary well ahead of the rel­a­tively young United States. Cit­ing the good track record of the US alone, and not all gov­ern­ments of equal ap­par­ent sta­bil­ity at the start of the same time pe­riod, is purest sur­vivor­ship bias.

The United States is a democ­racy; if enough peo­ple vote for rep­re­sen­ta­tives who de­cide not to pay off the bonds, they won’t get paid. Do you want to look at re­cent his­tory, let alone an­cient his­tory, and tell me this is im­pos­si­ble? The In­ter­net could en­able co­or­di­nated pop­ulist vot­ing that would sweep new can­di­dates into office, in defi­ance of pre­vous poli­ti­cal ma­chines. Then the US econ­omy melts un­der the bur­den of con­sumer debt, which causes China to stop buy­ing US bonds and dump its dol­lar re­serves. Then Al Qaeda fi­nally smug­gles a nuke into Wash­ing­ton, D.C. Then the next global pan­demic hits. And these are just “good sto­ries”—the prob­a­bil­ity of the US de­fault­ing on its bonds for any rea­son, is nec­es­sar­ily higher than the prob­a­bil­ity of it hap­pen­ing for the par­tic­u­lar rea­sons I’ve just de­scribed. I’m not say­ing these are high prob­a­bil­ities, but they are prob­a­bil­ities. Trea­sury bills are nowhere near “risk free”.

I may be prej­u­diced here, be­cause I an­ti­ci­pate par­tic­u­lar Black Swans (AI, nan­otech, biotech) that I see as hav­ing a high chance of strik­ing over the life­time of a 30-year Trea­sury bond. But even if you don’t share those par­tic­u­lar as­sump­tions, do you ex­pect the United States to still be around in 300 years? If not, do you know ex­actly when it will go bust? Then why isn’t the risk of los­ing your cap­i­tal on a 30-year Trea­sury bond at least, say, 10%?

Nas­sim Ni­cholas Taleb’s lat­est, The Black Swan, is about the im­pact of un­known un­knowns—sud­den blowups, pro­cesses that seem to be­have nor­mally for long pe­ri­ods and then melt down, vari­ables in which most of the move­ment may oc­cur on a tiny frac­tion of the moves. Taleb in­veighs against the dan­gers of in­duc­tion, the lu­dic fal­lacy, hind­sight, sur­vivor­ship bias. And then on page 205, Taleb sug­gests:

In­stead of putting your money in “medium risk” in­vest­ments (how do you know it is medium risk? by listen­ing to tenure-seek­ing “ex­perts”?), you need to put a por­tion, say 85 to 90 per­cent, in ex­tremely safe in­stru­ments, like Trea­sury bills—as safe a class of in­stru­ments as you can man­age to find on this planet. The re­main­ing 10 to 15 per­cent you put in ex­tremely spec­u­la­tive bets, as lev­er­aged as pos­si­ble (like op­tions), prefer­ably ven­ture cap­i­tal-style port­fo­lios. That way you do not de­pend on er­rors of risk man­age­ment; no Black Swan can hurt you at all, be­yond your “floor”, the nest egg that you have in max­i­mally safe in­stru­ments.

Does Taleb know some­thing I don’t, or has he for­got­ten to ap­ply his own prin­ci­ples in the heat of the mo­ment? (That’s a se­ri­ous ques­tion, by the way, if Taleb hap­pens to be read­ing this. I’m not an ex­pe­rienced trader, and Taleb un­doubt­edly knows more than I do about how to use Black Swan think­ing in trad­ing. But we all know how hard it is to re­mem­ber to ap­ply our finely honed skep­ti­cism in the face of handy pop­u­lar phrases like “risk-free bonds rate”.) Re­gard­less, I think that if you ad­vise your read­ers to in­vest 90% of their money in “ex­tremely safe” in­stru­ments, you should cer­tainly also warn that it had bet­ter not all go into the same in­stru­ment—no, not even Trea­sury bills or gold bul­lion. There is always risk man­age­ment, and you are always ex­posed to er­ror. The safest in­stru­ments you can find on this planet aren’t very safe.