Risk-on and risk-off are descriptive terms referring to changes in the attitude and approach investors take toward risk during different economic scenarios. When investors are risk-on, they tend to put more money into riskier investments, such as stocks. When investors are risk-off, money tends to flow more into less-risky assets, such as bonds. This behavior during risk-on periods drives prices up for high-risk assets, while prices for low-risk assets fall. The opposite happens during risk-off periods.
A financial advisor can help you craft an investment strategy that responds to changes in market sentiment.
Risk is the possibility that an investment will not meet its targeted return. If an investor purchases a stock expecting a 10% return within one year, there is always a chance that the stock will return less or more than 10%. This is the risk. Assigning a high level of risk to an investment doesn’t necessarily mean the investor is likely to lose money. It just means that the investment has a large possibility of not returning what is expected.
Risk is inherent in any investment. The level of risk varies depending on the asset class and the individual investment. For instance, common shares in small companies are higher in risk than U.S. Treasury securities. Small-cap stocks have a relatively high chance of doing better or worse than expected. US Treasuries, however, can reliably be expected to yield the stated return with little variation.
High optimism is the key trait of risk-on investing. During these periods, investors feel economic growth and rising corporate profits will continue. Risk-on periods are often characterized by market commentary focusing on volatility and referring to the “fear index.” Objective indicators of risk-on often include rising prices for stocks and falling prices for gold.
An investor pursuing risk may seek out stocks that have had a long period of price appreciation that doesn’t necessarily match their earnings growth, producing high price-earnings ratios. Small caps, emerging markets, junk bonds and commodities such as crude oil also gain in popularity. Risk-on is when foreign exchange traders flock to less-stable currencies such as Canadian dollars.
When forecasts for the economy and markets are negative or uncertain, that tends to bring on a risk-off mentality. This may evidence itself in market commentary by the use of terms such as “a flight to safety.” In investor behavior, it’s characterized by selling risky investments such as stocks and putting the money instead into less-risky investments such as bonds. Signs of a shift to risk-off investing may include rising prices for gold and decreasing bond yields.
Increased interest in bonds as an asset class isn’t the only characteristic of a risk-off environment. Risk also varies by individual securities. So investors in risk-off times are likely to shun junk bonds that pay higher rates of interest because they are issued by companies in distress or with uncertain futures. Instead, they will seek out government bonds, such as those issued by the United States, as well as investment-grade corporate bonds from well-established healthy businesses. These pay lower rates of interest but are more stable in price.
Risk-off investors may also favor high-dividend stocks over those whose prospects for gain are based on price appreciation. They also frequently turn to gold. And, especially if interest rates are rising, they put more funds into cash-like instruments such as money market funds.
Limits of Risk-On and Risk-Off Investing
Risk-on and risk-off investing are risk management tools, but they aren’t the only ones or at all times the most reliable. For instance, the idea behind risk-on and risk-off investing is that asset classes tend to move in certain directions when investor sentiment changes. However, those moves aren’t always consistent. Stocks and bonds can sometimes move in ways that surprise even seasoned observers.
Other approaches to risk management may suit individual investor risk tolerances and work better in the long run. These include dollar-cost averaging and regular rebalancing of a portfolio to better match individual risk tolerance
Risk-on investing happens during economic boom times when corporate profits are strong and the future seems rosy. It’s characterized by increased investor interest in riskier assets such as small-cap stocks and high-yield bonds. Risk-off investing is more popular when uncertainty increases or recession or outright crises occur. During risk-off periods, investors flock to low-risk investments such as Treasury bonds and gold.
Tips for Investing
A financial advisor can help you make investments that fit your level of risk tolerance and financial objectives. SmartAsset’s free tool matches you with up to three financial advisors who 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.
If you need help calculating your risk tolerance, this guide will help you factor in different considerations to determine how much risk you are willing to take on.
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