Investing in a risk-free asset like government bonds or treasury bills can help optimize portfolio returns when combined with risky assets like stocks. By balancing risk-free and risky investments, an investor can achieve higher returns for a given level of risk. This article will explore strategies for incorporating risk-free assets into an investment portfolio.
Risk-free Assets Reduce Overall Portfolio Risk
Investing part of a portfolio in risk-free government bonds or bills eliminates the risk and volatility associated with that portion of the portfolio. This lowers the overall portfolio risk compared to being fully invested in volatile assets like stocks. Reducing risk improves the risk-adjusted returns.
Risk-Free Assets Provide Stability to Portfolios
Risk-free investments like Treasury bills provide stability to a portfolio because their prices remain steady. This balances out the price swings of risky assets like stocks. So the overall portfolio value stays more stable over time.
Risk-Free Assets Allow Increased Exposure to Higher Returning Risky Assets
By providing stability, risk-free investments allow higher allocations to more profitable but risky assets like stocks. This enables an investor to earn greater returns for the same amount of risk.
Loan Leverage with Risk-Free Assets Increases Potential Returns
Investors can borrow at the low risk-free rate and invest in higher returning assets to increase portfolio returns. However, leverage also increases risk, so moderate leverage ratios are advisable.
In summary, allocating part of an investment portfolio to risk-free government bonds and bills helps reduce overall portfolio risk. This allows increased exposure to higher returning risky assets, improving returns for a given risk level. Additionally, leverage through risk-free borrowing can boost returns further. But leverage should be applied prudently.