There is a Risk Free Interest Rate or Risk Free Rate of Return

But there is no such thing as a risk free investment!

The risk free interest rate or risk free rate of return is the rate of return of an investment that in theory has no risk.

But in practice there is no such thing as a risk free investment!

In the real world, short-dated government bonds of the relevant currency are used to approximate the risk free rate.

Commonly, US Treasury bills are used for US currency, whereas a common choice for EURO investments are German government bills.

Why are these securities considered risk free? Because the likelihood of these governments defaulting is extremely low, and because the short maturity of the bill protects the investor from interest-rate risk that is present in all fixed-rate bonds.

Some governments can always print more money if they run short. But the value of the money may not remain the same! I say some governments because European Union governments have a problem in this regard.

They have exchanged their own currency for the EURO and can no longer print more money or devalue their currency to help them get out of trouble.


How to Use the Risk Free Rate

Any additional risk taken by an investor should be rewarded with a rate of return higher than the risk free rate (on an after-tax basis).

From a value investing perspective, additional risk that needs to be taken into account above the risk free rate includes company risk and general market risk.

General market risk may add on another three to four percent. So if the current risk free interest rate is say five percent (the short-dated bond rate), then your required return on your equity investment should be at least eight to nine percent depending on your view of the current state of the market (overheated or underdone?).

The company risk needs to be added on. But how can a percentage figure be placed on company risk? That of course depends on the company and the nature of its operations.

Some companies present limited risk if they have delivered stable earnings and regular and increasing dividend payouts over an extended period of time. So for these companies, add on up to three percent.

Other companies with large price to earnings ratios that are aggressively expanding by undertaking large acquisitions using borrowed money present much larger risk. So for these companies, add on up to seven percent instead.

So adding on a company risk factor of from three to seven percent would suggest a required return on your investment of between 12 and 16 percent, depending on the riskiness of the company and the overall state of the stock market.


To Conclude

The percentage risk free interest rate of return is used as a starting point to estimate the rate of return you should require when investing in a stock listed on the stock exchange. This rate commonly varies over time from four to six percent.

To this percentage figure should be added a percentage estimate of the general stock market risk, as well as a percentage estimate of the risk of investing in a particular company which varies from company to company.

Value investing involves investing with a margin of safety and within the investor's circle of competence.

So while the market risk can't be avoided, companies that represent value are generally those that recover the fastest after a market downturn.

Also, because value investors invest in companies that they know something about, company risk can be reduced.

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