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 110 age rule? ›
Age-Based Asset Allocation
For example, there's the rule of 110. This rule says to subtract your age from 110, then use that number as a guideline for investing in stocks. So if you're 30 years old you'd invest 80% of your portfolio in stocks (110 – 30 = 80).
What is the difference between risky and risk-free assets? ›
While risk-free investments offer safety, they typically provide lower returns compared to riskier options. In India, bank fixed deposits usually offer interest rates lower than the inflation rate, which means that your purchasing power may erode over time.
What is the 100 rule in investing? ›
Determining the allocation of assets is a pivotal choice for investors, and a widely used initial guideline by many advisors is the “100 minus age" rule. This principle recommends investing the result of subtracting your age from 100 in equities, with the remaining portion allocated to debt instruments.
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.
Are treasury bills risk-free assets? ›
T-bills are considered risk-free because you can be certain you'll get your money back. But risk and return are directly proportional, and T-bills offer very low returns on investment. Consequently, if you invest in T-bills, there's a risk you're foregoing the opportunity to earn a higher return elsewhere.
What is the rule of 55 years old? ›
This is where the rule of 55 comes in. If you turn 55 (or older) during the calendar year you lose or leave your job, you can begin taking distributions from your 401(k) without paying the early withdrawal penalty. However, you must still pay taxes on your withdrawals.
What is the rule of 72 used for in finance? ›
The Rule of 72 is a calculation that estimates the number of years it takes to double your money at a specified rate of return. If, for example, your account earns 4 percent, divide 72 by 4 to get the number of years it will take for your money to double.
What is the 120 age rule? ›
The Rule of 120 (previously known as the Rule of 100) says that subtracting your age from 120 will give you an idea of the weight percentage for equities in your portfolio.
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? ›
“Some perceive cash as a risk-free haven when equities and other markets become too volatile, while others may see it as more or less interchangeable with bonds,” he notes. “The fact is cash is a distinct asset class with its own properties, advantages and risks.
Does a risk-free asset have a beta? ›
The Beta of a risk-free asset is zero because the risk-free asset's covariance and the market are zero. By definition, the Beta of the market is one, and most developed market stocks exhibit high positive betas.
What is the Warren Buffett Rule? ›
The Buffett Rule is the basic principle that no household making over $1 million annually should pay a smaller share of their income in taxes than middle-class families pay. Warren Buffett has famously stated that he pays a lower tax rate than his secretary, but as this report documents this situation is not uncommon.
How to double money in 7 years? ›
All you do is divide 72 by the fixed rate of return to get the number of years it will take for your initial investment to double. You would need to earn 10% per year to double your money in a little over seven years.
How do I double money in 5 years? ›
One can also use this to compute the returns a portfolio should generate to double money in a given time period. If you want to double it in five years, the portfolio should be invested such that it yields 72/5=14.4%.
What is an example of a risk asset? ›
The risk assets examples include equities, commodities, high-yield bonds, real estate, and currencies (forex). Under the legal risk assets definition, the term refers to fixed-income securities that are not investment-grade securities, common stock, preferred stock, mortgage loans and real estate.
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.
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. There is, of course, a risk-return tradeoff, such that safer assets typically offer comparatively lower expected returns.
Are there any risk-free investments? ›
Treasury bills
Treasury bills are low-risk investments for a good reason: They're backed by the United States government, meaning there's not much chance of default. Also, T-bills have short terms to maturity of one year or less, which also limits risk.
