Risk-on vs. Risk-off: What Do They Mean?

In the trading world, the terms "risk-on" and "risk-off" are thrown about fairly frequently with regard to market sentiment. But what do these terms mean and how can understanding them help you make better investment decisions? 

In this article, we'll dive deeper into the meaning of risk-on and risk-off and explore what they can tell us about the financial markets.

What Does Risk-on Mean?

When market participants say the market is in a "risk-on" phase, it signals that investors are optimistic and willing to accommodate more risk in their investments. Investors express this sentiment in various forms, such as a shift in preference towards stocks over bonds or a greater inclination towards investing in emerging market stocks rather than developed market stocks. 

One example of a risk-on regime is the period of economic growth and expansion in the United States between 2001 and 2007. During this time, investors were willing to invest in more speculative assets, such as real estate and technology stocks, to achieve higher returns. This led to an increase in housing prices and a stock market rally, which ultimately ended in the financial crisis of 2008.

Essentially, during a risk-on phase, investors are willing to take on more volatility to achieve higher returns which drives the price of riskier assets up. Investors perceive a bullish economy and believe that the potential for higher returns outweighs the risks of higher market volatility. 

What Does Risk-off Mean?

When the market is considered "risk-off," investors are becoming increasingly cautious and looking to lower their exposure to potential losses. Risk-off sentiments show up in several ways, such as shifting investments from stocks to bonds or emerging market stocks to established market stocks. Investors crave more investment stability and are willing to accept lower returns as a trade-off for this increased safety.

During a risk-off period, investors may be more likely to move funds into safer investments, such as government bonds, which tend to be less volatile than other bonds or stocks. They may also choose to invest in utility stocks, which are seen as defensive investments that tend to perform well in a downturn.

In the run-up to the U.S. presidential election of November 2016, the financial markets viewed a Donald Trump victory as a more significant risk than the election of Hillary Clinton. As a result, as the media released more news in Trump's favor, investors became more risk-averse, moving their assets into less risky investments.

Generally, a risk-off market is characterized by a decrease in stock prices and an increase in bond prices. This is because when investors feel more cautious, they will tend to sell stocks and buy bonds which are considered safer investments. It can also portend an upcoming recession or economic downturn.

It's important to note that the terms "risk-off" and "risk-on" are relative and can change depending on the market conditions and investors' sentiment. They are not permanent states but describe temporary market conditions.

Is Bitcoin Risk-on or Risk-off?

Bitcoin is known for its high level of volatility, with prices that can fluctuate quickly and often dramatically. It is not backed by any physical assets or government and has no central authority regulating it. The lack of regulation and oversight can make it a riskier investment than traditional assets such as stocks or bonds.

Additionally, the value of Bitcoin is determined primarily by supply and demand in the market, which can be influenced by multiple factors such as market speculation, technological and regulatory changes and global economic conditions.

Generally, Bitcoin is considered a high-risk, high-reward investment, and it would fall in the "risk-on" category. 

However, for some Bitcoin purists, its sound money properties and potential as a store of value make it a risk-off asset. As a result, the jury is still out on a definitive risk-on, risk-off classification of Bitcoin.

What Are Typical "Risk off" Assets?

Typical "risk-off" assets are investments considered safer and less volatile than other investments. When investors are spooked and feel more cautious, they reduce their exposure to potential losses by seeking out these assets. Some examples of "risk-off" assets include:

• Government Bonds: Bonds issued by governments are considered to be among the safest investments. They typically offer a lower return than other bonds but are considered a more stable investment.

• Treasury Bonds: Treasury bonds are debt securities issued by the U.S. government and are considered among the world's safest investments.

• Certificates of Deposit (CDs): CDs are bank deposits that offer a fixed interest rate and a guaranteed return. 

• Money Market Funds: Money market funds are mutual funds that invest in short-term debt securities such as treasury bills and commercial paper. 

• Gold: Gold is considered a safe haven asset, and its value is uncorrelated to the stock market or bonds market. Gold retains its value during economic uncertainty, geopolitical tensions or inflation.

• Utility Stocks: Utility stocks are defensive investments that tend to perform well in a downturn. They are also considered low-risk investments.

Is Risk-On Risk-Off A Good Indicator of Market Sentiment?

The "risk-on, risk-off" terminology is often used to describe market sentiment and investors' preferences for riskier or safer investments. 

However, while the “risk-on, risk-off” classification can be a valuable description of market sentiments, it takes a broad brush to describe market changes. Other indicators, such as economic data, corporate earnings and political developments, can also shape market sentiment. It's also important to remember that market sentiment is not binary. It's a spectrum of emotion, with different degrees of risk-on and risk-off.

Overall, although the "risk-on, risk-off" terminology can provide some insight into market sentiment, it should not be used as the sole indicator of market sentiment. Investors should also consider additional nuances in the market, like company-specific news, when making investment decisions.

The Risk-On vs. Risk-Off Approach to Market Sentiment

"Risk-on" and "risk-off" are commonly used to describe market sentiment. These terms indicate changes in investment activity influenced by more significant shifts, such as in the broader economy. When the market is risk-on, investors feel confident and are willing to take on more risk. On the contrary, investors feel more cautious when the market is risk-off and want to reduce their risk exposure. 

While the “risk-on, risk-off” classification can be a helpful indicator of market sentiment, it's important to remember that you can drill down deeper into the cause. Macroeconomic data, corporate earnings, government policies and other factors can trigger market sentiment changes.