Risk-Free Rate Of Return
Candlefocus EditorThe concept of the risk-free rate (RFR) of return is relatively simple – it is the rate of return on the investment that has no risk. The rate is not returns-based, it is rather based on the security of the investment. It does not matter what the investor actually makes on the investment, as long as there is no risk associated with it, an investor would be willing to accept the RFR as the return.
In reality, there is no such thing as a ‘risk-free’ investment due to the traces of inflation, different tax rates, amongst other external factors. That is why, to calculate the real risk-free rate of return, inflation must be subtracted from the yield of the Treasury bond matching the investor’s desired duration of investment. If an investor chooses a shorter duration of investment, they will also be able to reduce the variable expenses associated with inflation by simply buying short-term bonds.
It is important to note that the risk-free rate of return is a measure used to help justify the decision on whether to invest in a certain asset or not, based on the corresponding risk. All investments come with risk and should be weighed carefully, however, determining the rate at which an investor may expect to return from a zero-risk investment gives them a benchmark against which all other investments can be judged.
Consequently, the risk-free rate of return is a key factor for investors who are minimizing their risk exposure and striving to reach their financial goals. The ability to identify and calculate the RFR is an essential element of private portfolio management.