What is the difference between risky assets and risk-free assets?
It is important to understand the distinction between risky and risk-free assets when investing. Risk assets are investments that have a high level of volatility, meaning their value can fluctuate significantly over a short period of time. In contrast, risk-free assets are investments considered safe and stable because they do not exhibit significant volatility.
Risk assets can include stocks, corporate bonds, commodities and currencies. These investments can offer high returns, but they also carry a risk of capital loss. For example, stocks can experience significant rises and falls depending on market conditions and company performance. Likewise, corporate bonds may become less profitable if the company experiences financial difficulties.
Risk-free assets, on the other hand, are typically low-yielding but stable investments, such as government bonds and savings accounts. Government bonds are considered safe because they are issued by governments and have a relatively low risk of default. Savings accounts, on the other hand, offer a capital guarantee and a fixed return, but returns are generally lower than those of risky assets.
When financial markets experience a period of uncertainty and volatility, there is often a rotation of investors into risk-free assets, in what is known as “risk-off”. Investors seek to protect their capital and minimize their exposure to risky investments. On the other hand, when there is confidence and optimism in the markets, investors tend to seek higher returns by investing in risky assets, in what is called “risk-on”.
In conclusion, the main difference between risk assets and risk-free assets is their level of volatility and return. Risky assets offer potentially high returns but also carry a risk of capital loss, while risk-free assets are considered safe but offer lower returns. Investors should consider this distinction when constructing their investment portfolio.