By Rebecca Lake
When building an investment portfolio, finding the right balance between risk and reward is essential for meeting your goals while keeping losses in check. One investing term you may have come across is the risk-free rate of return. While this concept is theoretical, it’s helpful for understanding how investment risk works and how to minimize it in your portfolio. For further guidance, consider enlisting the help of an expert financial advisor.
Risk-Free Rate of Return, Definition
Risk-free rate of return is a fairly simple idea. It refers to the rate of return you could earn over time on an investment that carries zero risk. So assuming an investment is completely risk-free, the risk-free rate of return would be what you would pocket by holding the investment.
The risk-free rate of return is often linked with U.S. Treasurys. Specifically, it’s considered to be equal to the interest earned on a three-month Treasury bill, which is one of the safest investment options. That’s because there’s an extremely low chance of the federal government defaulting on short-term debt obligations.
Risk-free rate of return is a theoretical number; it doesn’t actually exist in the real world. That’s because all investments, even ones that are among the safest, still carry some degree of risk. These risks can be tied to various factors, including stock market volatility, currency risk, credit risk and inflation risk.Uses for Risk-Free Rate of Return
You might be wondering why risk-free rate of return matters or how it’s used if it’s only a theoretical calculation. As an investor, it can be useful for determining the minimum return you’d expect to get for an investment without increasing the amount of risk you take on. In other words, before you’d commit to an investment you’d have to make sure that its rate of return has the potential to exceed the risk-free rate.
When building a portfolio, there are two components of risk to keep in mind. The first is your risk tolerance. This is the amount of risk you’re comfortable taking with your investments at any given time. So if you have a low risk tolerance, you might steer toward safer investments, such as money market accounts, bonds or certificates of deposit (CDs).
That type of conservative asset allocation can help insulate you against losses in your portfolio. But playing it too safe with your investments could cost you if your holdings aren’t generating enough returns to help you meet your goals. That’s where the second component, risk capacity, comes into play.
Risk capacity refers to the amount of risk you need to take to achieve your goals. Keeping risk tolerance and risk capacity balanced against one another can help ensure that your portfolio is designed to produce the returns you need and expect while minimizing the risk of losing money.
Understanding risk-free rate of return can help you keep both in perspective as you choose investments for your portfolio. Specifically, it can help with understanding how increasing or decreasing levels of risk in your investments can translate to returns. That can make it easier to select where and how to allocate your investment dollars, using the three-month T-bill as a guide.Risk-Free Rate and Weighted Average Cost of Capital
Risk-free rate of return can also have implications for investors beyond just measuring risk in a portfolio. It can also affect the weighted average cost of capital for companies. This means the average after-tax cost of common stock, preferred stock and other capital sources.
This value can be affected by the way the Federal Reserve sets interest rate policy. Risk-free rate of return is a component in determining the weighted average cost of capital. When interest rates increase, the risk-free rate increases as well. So securities that tend to be riskier, such as stocks, have to improve performance in a rising rate environment to hold investors’ interest.
Specifically, it means that investors will expect a higher rate of return to get them to take risks on those securities. This means a publicly traded company may take measures to drive share prices up and increase profitability, such as restructuring debt or expanding operations. While that puts more pressure on the company to perform, it can be a good thing for investors if your holdings increase in value.
But there can be a downside if a company isn’t able to keep up with investor expectations. For example, if a company takes on new debt to expand but the return on that investment falls short of goals, then that could increase the risk of defaulting on the debt. Or it could cause the company to cut back on outflows by slashing dividends in order to preserve capital. Either scenario could be bad for investors if the company’s stock value plummets or the dividend income they’re counting on dries up.Managing Risk in a Portfolio
Perhaps the easiest and best way to manage risk in your portfolio is understanding diversification and putting it to work. Diversifying means spreading your investment dollars across different types of securities that have higher and lower risk profiles.
So for example, a diversified portfolio might include a mix of stocks, bonds, cash and real statement. But within each of those categories, you can diversify further to manage risk.
Say you want to invest in stocks, for instance, You could diversify by choosing stocks with different market capitalizations or stocks that represent different sectors. The same is true for investing with mutual funds or exchange-traded funds. What’s key with investing in mutual funds or ETFs is to pay attention to the underlying holdings. If you own two funds that invest in many of the same companies, you could end up overweighted without realizing it and potentially increasing risk.
Bonds, on the other hand, are generally considered to be much less risky than stocks but they aren’t all alike. There are government bonds, corporate bonds and high-yield bonds, all of which have unique risk and rewards profiles. Knowing how different bond types operate and respond to interest rate changes and shifts in market risk can help you decide which bonds best fit your needs.The Bottom Line
Even though risk-free rate of return is a theoretical number, rather than an actual one, it still has value when making investment decisions. By using the risk-free rate of return as a guide, you can better construct a portfolio that aligns with your risk tolerance, risk capacity and overall objectives.Tips for Investing
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