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

Modern monetary theory (MMT)
Glossary

Modern monetary theory (MMT)

Modern Monetary theory, or MMT, has become popular on the left, both in the UK and abroad. (Wags say that it stands for "magic money tree".) 
21 Sep 2020
Price to sales ratio
Glossary

Price to sales ratio

A company's market cap divided by the company's annual sales (or revenue) gives us the price/sales ratio.
28 Aug 2020
Too embarrassed to ask: what is a p/e ratio?
Too embarrassed to ask

Too embarrassed to ask: what is a p/e ratio?

Find out how to use the price/earnings ratio (p/e ratio for short) – a useful starting place for investors looking to value a company.
26 Aug 2020
Stock split
Glossary

Stock split

A stock split increases the number of a corporation's issued shares by dividing each existing share.
21 Aug 2020

Most Popular

Oil producers are back at their Covid-19 lows – is it time to buy?
Oil

Oil producers are back at their Covid-19 lows – is it time to buy?

With demand for oil hammered by Covid-19 and talk of “peak oil demand”, there are lots of good reasons to be bearish on oil producers. So, asks John S…
22 Sep 2020
IAG's share price is ready for take-off - here's how to play it
Trading

IAG's share price is ready for take-off - here's how to play it

The owner of British Airways has had a turbulent year, but is now worth a punt. Matthew Partridge explains the best way to play it.
8 Sep 2020
Will a second wave of Covid lead to another stockmarket crash?
Stockmarkets

Will a second wave of Covid lead to another stockmarket crash?

Can we expect to see another lockdown like in March, and what will that mean for your money? John Stepek explains.
18 Sep 2020