Risk-on risk-off is an investment setting in which price behavior
responds to and is driven by changes in investor risk tolerance. Risk-on
risk-off refers to changes in investment activity in response to global
economic patterns.
During periods when risk is perceived as low, the risk-on risk-off
theory states that investors tend to engage in higher-risk investments.
When risk is perceived to be high, investors have the tendency to
gravitate toward lower-risk investments.
Understanding Risk-On Risk-Off
Investors' appetites for risk rise and fall over time. At times,
investors are more likely to invest in higher-risk instruments than
during other periods, such as during the 2009 economic recovery period.
The 2008 financial crisis
was considered a risk-off year, when investors attempted to reduce risk
by selling existing risky positions and moving money to either cash positions or low/no-risk positions, such as U.S. Treasury bonds.
Not all asset classes
carry the same risk. Investors tend to change asset classes depending
on the perceived risk in the markets. For instance, stocks are generally
considered to be riskier assets than bonds. Therefore, a market where
stocks are outperforming bonds
is said to be a risk-on environment. When stocks are selling off and
investors run for shelter to bonds or gold, the environment is said to
be risk-off.
Risk Sentiment
While asset prices ultimately detail the risk sentiment of the market, investors can often find signs of changing sentiment through corporate earnings, macroeconomic data, global central bank action and statements, and other factors.
Risk-on environments are often carried by a combination of expanding
corporate earnings, optimistic economic outlook, accommodative central
bank policies, and speculation.
We can also assume that an increase in the stock market is a sign that
risk is on. As investors feel the market is being supported by strong
influential fundamentals, they perceive less risk about the market and
its outlook.
Conversely, risk-off environments can be caused by widespread corporate
earnings downgrades, contracting or slowing economic data, uncertain
central bank policy, a rush to safe investments, and other factors. Just
like the stock market rises relating to a risk on environment, a drop
in the stock market equals a risk off environment. That's because
investors want to avoid risk and are averse to it.
Returns and Risk-On Risk-Off
As the perceived risk rises in the markets, investors jump from risky assets and pile into high-grade bonds, U.S. Treasury bonds, gold, cash, and other safe havens.
While returns on these assets are not expected to be excessive, they
provide downside protection to portfolios during times of distress.
When risks subside in the market, low-return assets and safe havens are dumped for high-yielding bonds, stocks, commodities,
and other assets that carry elevated risk. As overall market risks stay
low, investors are more willing to take on portfolio risk for the
chance of higher returns.