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

The long-awaited return of value stocks
Investment strategy

The long-awaited return of value stocks

For a few years we’ve been wondering when the gulf in valuation between “growth” stocks and “value” stocks will close. It might finally be happening, …
14 Jan 2022
Temple Bar’s Ian Lance and Nick Purves: the essence of value investing
Investment strategy

Temple Bar’s Ian Lance and Nick Purves: the essence of value investing

Ian Lance and Nick Purves of the Temple Bar investment trust explain the essence of “value investing” – buying something for less than its intrinsic v…
14 Jan 2022
Value stocks: when cheaper isn’t cheap enough
Value investing

Value stocks: when cheaper isn’t cheap enough

Value stocks will probably beat growth stocks in the years ahead, but that won’t necessarily mean high returns, says Cris Sholto Heaton
1 Jan 2022
Two outstandingly cheap UK stocks in an age of mad valuations
UK stockmarkets

Two outstandingly cheap UK stocks in an age of mad valuations

In these times of nutty company valuations, there is still plenty of opportunity around, says Merryn Somerset Webb. Take these two stocks, for example…
26 Nov 2021

Most Popular

Ask for a pay rise – everyone else is
Inflation

Ask for a pay rise – everyone else is

As inflation bites and the labour market remains tight, many of the nation's employees are asking for a pay rise. Merryn Somerset Webb explains why yo…
17 Jan 2022
Temple Bar’s Ian Lance and Nick Purves: the essence of value investing
Investment strategy

Temple Bar’s Ian Lance and Nick Purves: the essence of value investing

Ian Lance and Nick Purves of the Temple Bar investment trust explain the essence of “value investing” – buying something for less than its intrinsic v…
14 Jan 2022
US inflation is at its highest since 1982. Why aren’t markets panicking?
Inflation

US inflation is at its highest since 1982. Why aren’t markets panicking?

US inflation is at 7% – the last time it was this high interest rates were at 14%. But instead of panicking, markets just shrugged. John Stepek explai…
13 Jan 2022