Whether you are buying a house, a car, or anything else for that matter, it’s always worth it to "shop around" and find the best deal. But how do you shop around when it comes to buying a stock or mutual fund?
That’s where the risk-free rate of return comes in. It’s used as a benchmark to compare different types of assets. Learn more about what the risk-free rate of return is and how it's used to help investors make important decisions.
- A risk-free rate of return is the theoretical rate of return on an investment that has zero risk associated with it.
- There is no such thing as a true risk-free rate of return.
- The risk-free rate of return can help investors evaluate economic conditions and compare various assets.
What Is the Risk-Free Rate of Return?
When investors buy stocks, bonds, real estate, certificates of deposits, or any other assets, they expect to get a return on their money. They also expect more return from stocks than bank certificates of deposit because stocks have more investment risk. Investment risk is the possibility that an investment will not meet the expected return.
A risk-free rate of return is 100% predictable over a set period of time. There is no investment risk or risk of default, and investor expectations are always met. Unfortunately, in practice, there is no such thing as an investment without risk. U.S. government three-month Treasury bills and 10-year bonds are generally used as risk-free rates because they carry virtually no risk of default.
How the Risk-Free Rate of Return Is Used
The goal of any investment plan is to get as much return for the risk that you are willing to take. Three common measures used to manage the risk and returns of a portfolio are risk premium, the capital asset pricing model, and the Sharpe ratio. All three of them include the risk-free rates of return, so it’s important to understand how they work.
The risk premium tells investors how much they are getting paid for the risk they are taking. Risk premium compares the expected return of an investment to the return of a risk-free investment.
If you were considering buying a mutual fund as part of your retirement savings, here's how you might look at it. The below numbers are pulled from Dec. 16, 2020, data.
Risk-Free Rate of Return: The 10-year Treasury bond rate of .92%
Expected Investment Return: The 10-year historical return on the mutual fund of 8%
Risk Premium: 7.08%
Based on the assumptions, you will be paid 7.08% for the risk of the mutual fund. The risk premium tells you how much you're getting paid to take the risk, but it doesn't tell you if it's enough.
Capital Asset Pricing Model (CAPM)
Capital Asset Pricing Model calculates what return an investor should expect based on the risk. The formula for CAPM is as follows:
Notice that formula contains a risk premium. Typically, an average of historical risk premiums is used, and there are a lot of them to choose from.
Beta (𝛽) measures how much the return of a stock, bond, or other investment varies from the return of an index like the S&P 500, or Bloomberg total U.S. bond. The beta for a stock, bond, or mutual fund is usually included in the research that broker-dealers provide to their customers.
In our example, we'll use the 4.1% historical average risk premium of the U.S. stock market from 1927 and a chosen beta of 1.25.
Expected Return = 10 Year T-bond (.92%) + (Beta 1.25 x Risk Premium 4.1%)
Our expected return is 6.05%.
Risk premium tells investors how much they are getting paid to take risk, whereas CAPM tells investors how much they should expect to be paid for taking risk. The Sharpe ratio uses the risk-free rate of return to show investors how well a portfolio is meeting expected returns. In other words, it’s the smart shoppers guide to a good deal.
A Sharpe ratio of one or more is generally the target for a portfolio. Research on mutual funds and ETFs provided by broker-dealers usually include the Sharpe ratio.
The Real Risk-Free Rate of Return
The U.S. Treasury 10-year bond and three-month T-bill meet expectations in the sense that the return is 100% predictable. An investor, however, still has to contend with the risk of inflation. The real risk-free rate of return includes inflation.
As of Dec. 16, 2020, the 10-year Treasury bond was at .92%, and the annual 2020 rate of inflation was 1.2%, which means the risk-free rate fell below inflation.
10-Year Bond Rate (.92%) - Expected Inflation (1.2%) = -.28%
When the inflation rate exceeds the risk-free interest rate, as in our example above, the investor is losing money.
Even though U.S. Treasury bonds are used to set the risk-free rate of return, there is still the risk of inflation. A true risk-free rate of return is theoretical; it doesn't exist.
What the Risk-Free Rate of Return Means for Individual Investors
Risk-free rates of return are used to help investors evaluate their investment plans and asset allocations. They're also a way for investors to look at economic conditions. The Treasury term spread, the difference in return between the 10-year Treasury note and three-month Treasury bill, is used by the NY Federal Reserve to predict the probability of recession 12 months in the future.
The Treasury yield curve, or risk-free rate curve, shows the relationship between short-term Treasury rates and long-term Treasury rates from 30 days to 30 years. The shape of the curve is an indicator of how investors feel about the economy.
When the shape of the yield curve is normal, long-term rates are gradually higher than short-term rates and the economy is generally in a period of normal growth. A steep curve, though, often indicates the beginning of an economic expansion. As of January 2021, the yield curve is the steepest it’s been in four years, which means investors are optimistic about the economy.
A flat curve, when the gap between short-term and long-term rates is narrow, is an indicator of slowing growth. When short-term rates are higher than long-term rates, the curve is inverted. The yield curve has inverted ahead of every U.S. recession for the last 50 years.
Finally, the risk-free rate of return can influence stock prices. When risk-free rates of return are high, companies have to compete for investors to justify the additional risk. For an investor, a rising rate signals a confident treasury and the ability to demand higher returns. Meeting profitability and stock price targets become even more critical for corporate managers.