The Meaning Of Risk-On, Risk-Off Investing

Risk literally is exposure to the chance of injury or loss. The term risk and markets are interwoven, given the inseparability of both. The markets play on the
risk sentiment
of traders, given their vulnerability to greed and fear — the two most common emotions that drive traders in their investment decisions.

However, in economic parlance, human tendency is such that it attempts to reduce the uncertainty when exposed to uncertainty. A person may be reluctant to accept a bargain with a uncertain pay-off, rather than another bargain with a more certain, but possibly lower expected pay-off.

In the words of astute billionaire investor Warren Buffett, risk comes from not knowing what you're doing. Going by the saying, ignorance is bliss, is it OK to assume a risk taker is in a perfect blessed state? The reality is far from this.

Risky Bets, Safe Havens

An investor seeking to maximize his returns would be better off staying cognizant of what risky bets and safe havens are. Safe havens assure us a fixed return, although the magnitude of return may be small. Some of the safe havens are:

  • Gold.
  • U.S. Treasury Bills, as these are guaranteed by the government.
  • Among currencies, the yen, the dollar and the Swiss franc are considered safer bets.
  • Defensive stocks such as utilities, consumer staples, etc. (these stocks yield fixed dividends and stable earnings, defying the state of the broader market). Defensive stocks have a beta value of less than 1 and perform better when the market during recessions and underperform the markets during expansions.

Investments that offer a high rate of return in a short period make them risky bets. Equities, commodities, risk currencies such as the Australian, New Zealand and Canadian dollar, the pound, etc., having higher yields, could qualify as risky bets. Even amid these asset classes, one can minimize risk exposure by investing in the following avenues.

  • IPOs.
  • Portfolio investment, comprising asset classes that cancel out or neutralize the risks involved.
  • Trading in options, Futures, ETFs, etc.
  • Hedging.

Risk-On/Risk-Off Investing: Putting It In Perspective

A risk-on mood refers to investors' willingness in investing in risky bets. This happens when investor sentiment concerning the economy, geopolitics, industry and the asset in question is positive. Under such a scenario, investors divert their investments into risky bets.

Meanwhile, when uncertainty concerning the overall conditions drive traders crazy, they prefer pulling their investments out from risky bets, despite the attractiveness of the returns and instead lap up safe havens that at least would keep their base investment safe.

In recent days, oil has been volatile amid contrasting expectations concerning output quota cut by OPEC members. Uncertainty concerning further Fed rate tightening, the Brexit vote, the near-term risk of the U.S. presidential elections and China's flailing recovery and concerns surrounding the health of major global financial institutions have all served to curb risk appetite of investors.

Risk-off mode is in the works in the markets currently, and this has kept the markets subdued, preventing any meaningful upside. However, year-end window dressing of portfolios could bring risk back into the markets and knowledge of where to put your money in different scenarios could make you a better informed, astute investor. Stay Smart and Stay Invested!

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Posted In: riskRisk ManagementRisk/RewardWarren BuffettEducationTop StoriesPersonal FinanceGeneral