Investing in financial markets involves a delicate dance between risk and reward, and investors often grapple with the challenge of gauging market sentiment. Two terms that frequently emerge in discussions about market sentiment are “risk-on” and “risk-off.” Understanding these concepts is crucial for investors seeking to align their investment strategies with prevailing market conditions.
Risk-on: Embracing higher returns and higher risk 
When the investment climate is described as “risk-on,” it signifies a sentiment among investors that favours higher-risk assets in pursuit of potentially higher returns. During risk-on periods, investors tend to be more optimistic about economic prospects, and confidence in financial markets is high. Consequently, investors allocate capital towards higher risk asset classes which have the potential for greater returns as investors are less concerned about the elevated risk during this time. Some asset classes that perform well during risk-on periods are:
- Equities: Share markets often thrive in a risk-on environment as investors show a preference for shares in companies with growth potential.
- Commodities: Risk-on sentiment can lead to increased demand for commodities, such as oil and industrial metals, driven by expectations of robust economic activity.
- High-yield bonds: Investors may seek higher yields by investing in bonds with lower credit ratings, accepting greater default risk.
Risk-off: Seeking safety amid uncertainty
Conversely, during “risk-off” periods, investors adopt a more cautious approach, prioritising capital preservation over higher returns. This sentiment prevails when economic uncertainties arise, geopolitical tensions escalate, or there is a general lack of confidence in financial markets. In a risk-off environment, investors tend to reallocate their portfolios towards safer assets, often characterised by lower volatility and greater stability. Some of the asset classes investors favour during risk-off periods are the following:
- Government bonds: During risk-off periods, investors seek the relative safety of government bonds, especially those issued by stable and creditworthy countries such as the United State or Germany.
- Gold: Considered a safe-haven asset, gold often experiences increased demand when investors turn risk-averse.
- Defensive shares: Companies in sectors like utilities and consumer staples, which typically exhibit stable earnings despite economic downturns, may become more attractive during risk-off phases.
Market indicators of risk sentiment
Understanding whether the market is in a risk-on or risk-off mode is crucial for making informed investment decisions. Several indicators can provide insights into prevailing sentiment:
- Volatility Index (VIX): Often referred to as the “fear gauge,” the VIX measures market expectations for future volatility. Higher VIX levels are associated with risk-off sentiment amongst investors.
- Currency movements: Safe-haven currencies, such as the U.S. dollar and the Japanese yen, may strengthen during risk-off periods, while higher-yielding currencies, such as the South African rand and other developing country currencies, may weaken.
- Government bond yields: Falling yields on government bonds are indicative of risk-off sentiment, as investors seek the safety of fixed-income assets.
In addition to the above there are a few other leading indicators investors usually look out for to determine future changes in market sentiment. One is to carefully assess and analyse the tone of central banks and other financial institution that will give an indication of how they are preparing for possible changes. Their opinions are usually informed by current and relevant market data and statistics of the economy giving them good insights of what is to come. Technical analysis may be another leading indicator where investors are very sensitive to any repeating patterns that may predict future behaviours that can turn the market sentiment.
Think of these opposite sentiments in the market as the wind changing direction and by understanding how to identify changes you can better adjust your sails to ensure you still reach your destination.
In the dynamic world of financial markets, recognising the nuances between risk-on and risk-off sentiment is essential for investors seeking to navigate uncertainties and optimise their portfolios. Monitoring economic indicators, geopolitical developments, and market volatility can provide valuable insights into the prevailing sentiment, enabling investors to adjust their strategies accordingly and strike a balance between risk and reward.
