How Risk-Free Assets Affect Portfolio Return and Volatility

Imagine your investment portfolio as a vibrant, flavorful juice blend. It’s full of different fruits representing various stocks, bonds, or other assets, each contributing its unique taste, or in financial terms, its return and risk. Now, what happens when you decide to add some water to this juice? The water, in our analogy, represents a risk-free asset.

Think of a risk-free asset as the financial equivalent of water. It’s something incredibly safe, offering a return that is virtually guaranteed, albeit usually quite low. A common example is government treasury bills from a very stable economy. These are considered risk-free because the chance of the government defaulting is extremely low, making the promised return almost certain. While no investment is truly 100% risk-free in all situations, for practical purposes, we consider these assets to have negligible risk.

When you allocate a portion of your investment funds to this risk-free asset, you are essentially adding water to your flavorful juice blend. What happens to the overall taste? It becomes diluted, less intensely flavored. Similarly, the expected return of your portfolio will be affected. Since the risk-free asset offers a lower return compared to riskier assets like stocks, adding it to your portfolio will generally decrease the overall expected return. It’s a simple weighted average effect. If part of your portfolio is now earning a very low, but guaranteed, return, the total portfolio return will naturally be pulled downwards compared to a portfolio composed solely of higher-returning, but riskier, assets.

Now, consider the volatility, or the ‘spiciness’ of our juice blend. Volatility in investments is the degree to which the value of your portfolio can fluctuate up and down. Assets like stocks are generally considered more volatile, meaning their prices can swing quite dramatically. Risk-free assets, by their very nature, have extremely low or virtually zero volatility. Think of water again – it’s very stable, its ‘price’ doesn’t jump around wildly.

When you introduce a risk-free asset into your portfolio, you are adding this element of stability. It’s like adding a calming ingredient to a potentially turbulent mix. The overall volatility of your portfolio will decrease. This is because the risk-free component acts as an anchor, reducing the impact of the more volatile parts of your portfolio. Even if your stock investments experience a downturn, the portion in the risk-free asset remains stable, cushioning the overall portfolio from significant swings.

Let’s illustrate with a simple example. Imagine you have a portfolio solely in stocks, which might have an expected return of, say, 8% and a volatility of 15%. Now, you decide to allocate 50% of your portfolio to a risk-free asset that offers a 2% return and zero volatility. Your new portfolio is now half stocks and half risk-free assets.

The expected return of this new portfolio would be roughly the average of the two. It won’t be a simple 5% as it’s weighted, but it will definitely be lower than the original 8%. Imagine it lands around 5%. Crucially, the volatility will also be significantly reduced. Because half of your portfolio is now in a completely stable asset, the overall portfolio volatility will be much lower than the original 15%. It might drop down to around 7.5% or even less, depending on the correlation between the assets, which in this simplified example, we are assuming is not working against us.

In essence, adding a risk-free asset to your portfolio is a way to dial down both the potential highs and the potential lows. You are trading off some potential return for a smoother, less bumpy investment journey. This is a very common and important strategy for investors, especially those who are more risk-averse or are approaching retirement and need to protect their capital. It’s about finding a balance between growth and stability, and the allocation to risk-free assets is a key lever in achieving that balance. You are effectively creating a portfolio that is less intensely flavored, less volatile, but perhaps more palatable for your specific risk appetite and investment goals.