Risk-free rate

One way to think about the size of return you should be aiming for is to consider the return you could get if you took absolutely no risk at all – the “risk-free rate of return”.

When you decide to invest in equities, or property, or bonds, or anything else, the return you expect to get should reflect the amount of risk you are taking. In theory (though not always in practise), the more risk you shoulder, the bigger the return you should expect. One way to think about the size of return you should be aiming for is to consider the return you could get if you took absolutely no risk at all the "risk-free rate of return".

Clearly, there is no such thing as a 100% risk free asset. Globally speaking, the risk-free rate usually describes the return you can get on US Treasury bills, a short-term American government IOU. No sovereign debt not even that issued by America - is entirely risk-free, but US debt is generally seen as being as close to risk-free as you can get. The US, as the world's most important economy with the world's most important currency, is highly unlikely to default in nominal terms (as it can always print its own currency if pushed). For UK investors (who would incur currency risk if buying US Treasuries), UK government-issued gilts would provide the risk-free rate.

The risk-free rate fluctuates over time. Currently, partly because of high demand for "safe" assets following the 2008 crash, but largely as a result of quantitative easing and other efforts by central banks to cut interest rates, the risk-free rate is either negative in "real" terms (after inflation) or even in nominal terms (in some parts of Europe in particular, you still effectively have to pay to lend to governments, as noted in the main story above). As a result, investors who are seeking a "real" return, have been forced to take on more risk investing in equities or corporate debt, for example whereas in the days before the financial crisis, it was possible to achieve a 2%-plus real return simply by investing in "safe" government debt.

Recommended

Deliveroo’s IPO flop shows which way the market is going
Stockmarkets

Deliveroo’s IPO flop shows which way the market is going

Deliveroo’s disastrous IPO is a good example of how investors are looking away from loss-making growth stocks and more towards companies that will pro…
6 Apr 2021
Overlooked European stocks are a solid bargain
European stockmarkets

Overlooked European stocks are a solid bargain

The lack of speculative exuberance in European stocks compared to US markets bodes well for investors seeking less tech-heavy drama and more deep valu…
26 Mar 2021
Temple Bar investment trust: a return to value
Investment trusts

Temple Bar investment trust: a return to value

Merryn talks to Nick Purves and Ian Lance of the Temple Bar Investment Trust about the shift in the investment landscape and the value available in UK…
5 Mar 2021
The great rotation is firmly underway – what does it mean for you?
Stockmarkets

The great rotation is firmly underway – what does it mean for you?

As investors move away from “jam tomorrow” stocks and back into “old economy” stocks that should benefit from the post-pandemic recovery, the tech-hea…
5 Mar 2021

Most Popular

The times may be changing, but don’t change how you invest
Small cap stocks

The times may be changing, but don’t change how you invest

We are living in strange times. But the basics of investing remain the same: buy fairly-priced stocks that can provide an income. And there are few be…
13 Sep 2021
Two shipping funds to buy for steady income
Investment trusts

Two shipping funds to buy for steady income

Returns from owning ships are volatile, but these two investment trusts are trying to make the sector less risky.
7 Sep 2021
How to stop recurring subscriptions becoming a drain on your money
Personal finance

How to stop recurring subscriptions becoming a drain on your money

Tracking and pruning subscriptions isn’t as easy as it sounds. Here's how to take charge.
14 Sep 2021