The risk-free rate is the rate of return on an investment that carries no risk of loss.
Every investment carries with it some level of risk. Nevertheless, investment managers often assume that certain high-quality, short-term bonds investments are very nearly risk free. The current rate of return on those investments is thus the risk-free rate.
When evaluating other investments, investment managers use the risk-free rate as a baseline. While usually not zero, the risk-free rate nevertheless signifies a rate that any other investment must beat since all other investments imply higher risk.
Investing is a balancing act of risk and return. In a perfect world, you could earn a steady return without taking on any risk, but the reality is that risk is nearly unavoidable. A company’s stock price can decline or the company itself might go bankrupt. A bond can default or lose face value.
Generally speaking, investments that carry a higher level of risk can produce a higher level of reward. That makes intuitive sense but fails to take into account a number of variables.
For instance, you might not be able to personally withstand an investment that seems to lose value in a short period of time, even if you think it will rise in price later on.
The risk is that you will take action on an investment when action is not warranted. If your expectation is that an investment will only go up in price while you own it, a contrary move might cause you to sell.
If you sell, of course, you immediately lock in that loss forever. The risk was not that the price of the investment changed but how you reacted to that change in the short run.
The movement of investment prices is known as volatility. It’s a measure of how high or low value goes in relation to the long-term average value of that investment.
More volatile investments often produce better results over long periods, but they also are more likely to be the companies that go out of business or the bonds that default, leaving investors will a fraction of their initial investment.
This calculation gets even trickier when considering foreign investments, which are affected by currency rate changes.
Knowing the risk-free rate allows an investor to gauge correctly how much risk to take when considering a new investment idea. If the risk-free rate is 1% then an investment must return more than 1% to warrant taking any risk at all.
The bottom line is that a zero return is not a reasonable assumption for risk-free return. Even cash in the bank earns less than zero, considering inflation.