What is a Risk-Free Asset
A risk-free asset has a certain future return. They consider treasuries (especially T-bills) being risk free because the government backs them in most countries. Because they are so safe, the return on risk-free assets is close to the current interest rate.
Many academics say there is no such thing as a risk-free asset because all financial assets carry risk. Technically, this may be correct. However, the level of risk is so small that, for the average investor, it is appropriate to consider U.S. Treasuries or Treasuries from stable Western governments to be risk free.
Breaking Down Risk-Free Asset
While we know the return on a risk-free asset, this does not guarantee a profit regarding purchasing power. Depending on the time until maturity, inflation can cause the asset to lose purchasing power even if the dollar value has risen as predicted.
When an investor takes on an investment, there is an expected return rate expected depending on the duration they hold the asset. It shows the risk because the actual return and the expected return may be very different. Since market fluctuations can be hard to predict, we consider the unknown aspect of the future return being the risk. An increased level of risk shows a higher chance of large fluctuations, which can translate to significant gains or losses depending on the ultimate outcome.
I consider risk-free investments being reasonably certain to gain at the level predicted. Since we know this gain, the rate of return is often much lower to reflect the lower amount of risk. The expected return and actual return are likely to be about the same.
For a long-term investment to continue to be risk free, any reinvestment necessary must also be risk-free. The exact rate of return may not be predictable from the beginning for the entire duration of the investment.
For example, if a person invests in six-month Treasury bills, the rate of return on the initial Treasury bill that was purchased may not be equal to the rate on the next Treasury bill purchased as part of the six-month reinvestment process. In that regard, there is a risk over the long term, since the rates may change between each instance of reinvestment, but it guarantees the risk of achieving each specified returned rate for the six months covering a particular Treasury bill’s growth.