When the market fluctuates, some investors get scared and want to eliminate risk from their portfolios. Risk-free assets provide a safe harbor against market volatility, but that safety comes at a cost. These investments tend to have low rates of return, which can reduce your ability to meet your financial goals. Learn what risk-free assets are, their pros and cons and if they belong in your portfolio.
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What Are Risk-Free Assets?
A risk-free asset is an investment with a guaranteed future value and virtually no potential for loss. Debt issued by the U.S. government (bonds, notes and Treasurys) is one of the most well-known risk-free assets. While these assets are no longer backed by gold assets, they are backed by the “full faith and credit” of the United States.
Investors shift their portfolios into risk-free assets during periods of uncertainty. U.S. Treasury bills are generally regarded as the safest investment in the world, which is why domestic and foreign investors buy so many during a downturn.
Other risk-free assets include:
- Treasury Inflation-Protected Securities (TIPS)
- Checking accounts
- Savings accounts
- Money market accounts
- Certificates of deposit (CDs)
Annuities, municipal bonds and money market funds are low-risk investments that some investors purchases. They tend to offer higher rates of return than risk-free investments in exchange for slightly more risk. In most cases, they will retain their value, but it is not guaranteed like a risk-free asset is.
Pros and Cons of Risk-Free Assets
Pros
- Avoid losses in the market. When you invest in risk-free assets, your portfolio is no longer subject to losses in the value of stocks and other investments. This strategy can protect your nest egg from losing money in an economic downturn.
- Guaranteed returns. Risk-free assets generally provide guaranteed returns that you agree to when you invest. If there are changes in future rates of return, risk-free assets provide notice ahead of time.
- No risk of default. Investors buying risk-free assets are certain that their money will be there for them when they need to withdraw it. With stocks and other risk-on assets, there are no guarantees that the investment will be worth anything in the future.
Cons
- Difficult to time the market. When you pull your money out of the market, you not only have to decide when to sell but also when to buy. You may get one decision right, but it’s difficult to choose the best dates for both.
- Low rates of return. By eliminating risk, you also give up the potential for higher returns. Guaranteed investments tend to have some of the lowest rates of return of any investments.
- May require locking up money for an extended timeframe. Depending on which risk-free assets you invest in, your money may be stuck there for a while. For example, CDs, U.S. Treasuries, TIPS and others have penalties if you withdraw before their maturity dates.
- Inflation erodes buying power. While safety may be appealing in the short term, inflation will reduce the value of your risk-free assets over time. It is important to have assets that outpace inflation to maintain your purchasing power.
Should You Have Risk-Free Assets in Your Portfolio?
Many investors choose to have a portion of their portfolios in risk-free assets. These assets provide a hedge against market downturns and the ability to buy more shares in risk-on assets when prices are down.
It is also wise to keep your emergency fund money in risk-free assets. This money is there when you need it most to cover unexpected expenses. Because of this, earning a high rate of return is not a focus for your emergency fund assets.
Retirees often keep one-to-two years’ worth of expenses in risk-free assets. This provides a pool of money that they can tap into for monthly income during a market downturn. Doing so prevents retirees from selling assets at lower values to pay for their monthly expenses.
Bottom Line
Risk-free assets provide a safe haven for investors during turbulent times. They offer guaranteed returns without the probability of loss. While these returns can be minimal, investors can rest easy knowing that their portfolio value is not declining. It can make sense to shift into risk-free investments in uncertain times, but they are not a wise choice for long-term investing because inflation will erode their value over time.
Tips for Reducing Risk in Your Portfolio
- Financial advisors can share numerous options with investors to reduce risk in their portfolios. These strategies are personalized to your unique goals, risk tolerance and timeframe.SmartAsset’s free tool matches you with up to three financial advisorswho serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- One of the most popular strategies for reducing risk is diversification. Having a broad array of investments allows investors to minimize loss and participate in gains in other market sectors. Our asset allocation calculator shares example portfolios based on your answers to a simple questionnaire.
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FAQs
Risk-free assets generally provide guaranteed returns that you agree to when you invest. If there are changes in future rates of return, risk-free assets provide notice ahead of time. No risk of default. Investors buying risk-free assets are certain that their money will be there for them when they need to withdraw it.
What is considered a risk-free asset? ›
A risk-free asset is one that has a certain future return—and virtually no possibility of loss. Debt obligations issued by the U.S. Department of the Treasury (bonds, notes, and especially Treasury bills) are considered to be risk-free because the "full faith and credit" of the U.S. government backs them.
What is the difference between risky and risk-free assets? ›
Answer and Explanation:
Risky assets have higher returns than the risk-free rate since the risk carried by them must be compensated. Hence, the return on the risky asset consists of the risk-free rate of return and the risk premium which compensates for the investor's uncertainty about future rates of return.
Do risk-free assets have volatility? ›
Since risk-free assets typically mature in three months or less, the volatility measure is very short-term in nature. While daily prices relating to yield can be used to measure volatility, they are not commonly used.
What is the US risk-free rate? ›
The risk-free rate is the rate of return of an investment with no risk of loss. Most often, either the current Treasury bill, or T-bill, rate or long-term government bond yield are used as the risk-free rate. T-bills are considered nearly free of default risk because they are fully backed by the U.S. government.
How do you calculate the risk-free asset? ›
The formula for the risk-free rate of return is simple. It's based on what investors are willing to earn for taking no risk at all. The value of a risk-free rate can be figured out by subtracting the current inflation rate from the total bond yield. This would apply for the duration of the bond.
Why invest in risk-free assets? ›
They have advantages like safe investment options, guaranteed returns, no default on principal and interest payments, stabilized mixed portfolios, low risk, and providing a safety net in times of inflation and recession.
Is cash a risk-free asset? ›
Even cash, as mentioned, carries the risk of losing value because of inflation, and it's also possible that inflation will outpace your investments in Treasurys.
What is considered a risky asset? ›
Risk assets are assets that have significant price volatility, such as equities, commodities, high-yield bonds, real estate, and currencies.
What is the risk and return of a risk-free asset? ›
The introduction of a risk-free asset extends investment options. By definition, the risk- free asset has the same return in all states of the world. Thus, the variance (and standard deviation) of the risk-free return is zero since the expected return and possible returns are the same in all states of the world.
Clearly the best portfolio to hold in combination with the riskfree rate is the tangency portfolio because it has the highest slope. Any other portfolio would be inefficient. The line between the riskfree rate and the tangency portfolio is called the capital allocation line.
What is the efficient frontier of a risk-free asset? ›
If a risk-free asset is also available, the opportunity set is larger, and its upper boundary, the efficient frontier, is a straight line segment emanating from the vertical axis at the value of the risk-free asset's return and tangent to the risky-assets-only opportunity set.
How do you calculate the variance of a portfolio with a risk-free asset? ›
Because the risk-free rate is constant, the portfolio variance only depends on the variability of the risky asset and is given by: σ2p=var(Rp)=var(xR)=x2σ2.
Are treasury bills really risk-free? ›
While interest rates and inflation can affect Treasury bill rates, they're generally considered a lower-risk (but lower-reward) investment than other debt securities. Treasury bills are backed by the full faith and credit of the U.S. government. If held to maturity, T-bills are considered virtually risk-free.
What is the best risk-free rate? ›
U.S. Treasuries are seen as a good example of a risk-free investment since the government cannot default on its debt. As such, the interest rate on a three-month U.S. Treasury bill is often used as a stand-in for the short-term risk-free rate, since it has almost no risk of default.
Why do we use 10 year Treasury as risk-free rate? ›
The 10-year Treasury yield is closely watched as an indicator of broader investor confidence. Because Treasury bonds (along with bills and notes) carry the full backing of the U.S. government, they are viewed as one of the safest investments.
What is an example of a risk asset? ›
A period of a rise and a subsequent fall off in value of unregulated cryptocurrency is another example of a risk asset experiencing the fluctuations indicative of the market. After cryptocurrencies such as Bitcoin saw increased use for transactions, including on "darknet" markets, their value saw rapid growth.
What are the safest assets? ›
Safe assets are those that allow investors to preserve capital without a high risk of potential losses. Such assets include treasuries, CDs, money market funds, and annuities.
Which asset has the least risk? ›
Key Takeaways
- Understanding risk, including the risks involved in investing in the major asset classes, is important research for any investor.
- Generally, CDs, savings accounts, cash, U.S. Savings Bonds and U.S. Treasury bills are the safest options, but they also offer the least in terms of profits.
1. U.S. Treasury Bills, Notes and Bonds. U.S. Treasury securities are backed by the full faith and credit of the U.S. government. Historically, the U.S. has always paid its debts, which helps to ensure that Treasurys are the lowest-risk investments you can own.
