WHAT IS RISK-ON RISK-OFF?
Risk-on risk-off happens when price behavior is driven by changes in investor risk tolerance. Risk-on risk-off refers to changes in investment activity in response to global economic expectations.
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.
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 growing corporate earnings, positive economic outlook, supportive central bank policies, and other factors. 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 fundamentals, they perceive less risk about the market and its outlook.
Conversely, risk-off environments can be caused by general 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 higher risk. As overall market risks stay low, investors are more willing to take on portfolio risk for the chance of higher returns.
Example of Risk on Risk off market moves
· If Nasdaq is Up, then Risk is ‘on’
· If Nasdaq is Down, then risk is ‘off
When money is chasing return and market mood is improving, capital tends to favor equities.
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April 14, 2020