While hardly a household name, Dr. Harry Markowitz developed a new way of looking at savings and investment that has fundamentally changed the financial world. In the 1950’s, Markowitz quantified the benefits of diversification in one’s savings. Prior to his work, most investors thought in terms of individual good and bad investments, but Markowitz proved that the best approach is to consider how an overall portfolio performs. Among the many assumptions in the application of Markowitz’s Modern Portfolio Theory is the notion that US Treasury Bills are risk free. With the US assuming far more liabilities than it can likely service, this assumption is becoming more dubious by the day. The implications for savers and investors tell a story of how government benefits debtors at the expense of savers.
Modern Portfolio Theory’s penultimate conclusion is that the best portfolio is a mix between a risk free asset and a portfolio of all risky assets together. By altering the mix of these two assets, an investor can build the best portfolio for his or her risk tolerance.
The chart shows Return On Investment going up as risk (Standard Deviation) moves to the right. The line marked ‘CAL’ for Capital Allocation Line shows how an investor can choose a mix of a risk free asset and a portfolio of risky assets (the Tangency Portfolio) to get the best return for any given level of risk. If an investor wants a return higher than the Tangency Portfolio, he would borrow money to move along the CAL ever higher. Investors who operate to the left of the Tangency Portfolio are savers, while those to the right are in part borrowers.
Again, the slope of the CAL is dependent on the risk free rate of return. If US T-Bills are the basis for the risk free rate assumption, the current debt crisis affects the risk assumptions of investors. While ratings agencies still grant US debt a ‘AAA’ rating, global trust in the US’s ability to service its obligations is slipping. As the US’s default risk increases the yield on its T-Bills will also increase. So long as investors continue to wrongly assume that US T-Bills are risk free, the slope of the CAL will be too shallow. Savers will be taking more risk than they think they are and borrowers will be taking less.
The end result is that otherwise rational savers will be inclined to lend more to the US Treasury because they can achieve their return goals with a higher mix of Treasuries. However, their true risk will be higher than their tolerance for such risk. Savers will underwrite the risk of US default. Conversely, borrowers will be incented to take more risk to achieve their return goals, but will be taking less real risk because of the risk underwriting savers will be donating to the treasury.
The wrong assumption of US T-Bills as being risk free causes savers to assume the default risk of borrowers without compensation. Of course the obvious solution is to stop assuming US T-Bills as being risk free, but remember that a wide variety of Mortgage Backed Securities were rated ‘AAA’ right up to the point they collapsed. The Markowitz Modern Portfolio Theory is another example of how excessive government debt transfers wealth and security from those who save to those who borrow.