What is risk-on risk-off?

The definition of risk-on-risk-off (RORO) is that it's an investment setting in which price behaviour responds to and is driven by changes in investor risk tolerance.

Put simply, when global economic patterns are favourable, traders are likely to be more risk-on and invest in higher-risk assets to maximise their returns. However, when markets tumble, traders will seek safety and invest in risk-off assets.

Key takeaways

Risk-on: Investors take higher risks in pursuit of higher returns in favourable economic conditions.
Risk-off: Investors avoid higher risks and prioritise preserving their capital in unfavourable economic conditions.
Risk management: Traders can use risk management tools, but it is impossible to eliminate risk completely.

Understanding risk-on risk-off

Risk-on-risk-off is an investment behaviour which involves traders moving money into or out of risky assets, depending on the economic climate.

When traders believe that economic conditions are improving, they tend to move money into riskier investments, such as stocks or commodities. This is known as the risk-on strategy.
When traders believe that economic conditions are deteriorating, they tend to move money out of riskier investments and into safer investments such as bonds or cash. This is known as a risk-off strategy.

If the financial markets are declining or volatile, like what was seen during the 2008 financial crisis, traders will adopt a more risk-off strategy, and place their capital in less riskier assets. However, when the markets are buoyant, then traders will place their capital in assets that carry more risk.

Importance of RORO in financial markets

Risk-on risk-off is an important concept in the financial world as it helps traders understand the cyclical nature of the markets, as well as trends and also where best to place their capital. Below are some other reasons why RORO is important.

Help manage risk: RORO strategies can help traders to manage their risk.
Inform traders: Risk-on risk-off can inform traders on investment decisions, and where to place their money.
Forecasting: RORO enables traders to forecast shifts in the the global economic climate.

Some tips on how to use RORO

Analyse: Use tools such as technical and fundamental analysis to identify trends in the market. This can help you to use RORO strategies better.
Diversification: Diversifying your portfolio with a mixture of assets can help minimise risk during times of economic volatility.
Stay ahead: Remain informed about economic events and how it may affect RORO.
Study: Look at previous RORO cycles and study how they have affected the markets.

Risk sentiment

Risk is a natural part of investing, whether the investment is in stocks, bonds, commodities or forex, there will be some level of risk associated with it. Understanding risk will help you when looking at risk-off vs risk-on strategies.

Risk sentiment is used to describe how financial markets (traders and investors) are behaving and feeling. What traders decide to buy or sell, also means balancing how much they are prepared to lose, and what their expected return may be.

Traders can often find signs of changing sentiment through corporate earnings. For example, a company’s forecast being downbeat and pointing to less growth in the upcoming quarter could be a sign of changing sentiment.

Traders can also look for signs in macroeconomic data, for example, how central banks are responding to rising or low inflation, could be a sign of changing sentiment.

Risk-off vs risk-on

Below are some characteristics of risk-on and risk-off environments.

Risk-on	Risk-off
Central banks are optimistic	Central banks are less optimistic and uncertain
Corporate earnings reflect a positive outlook	Corporate earnings reflect a negative e outlook
Market commentary is positive	Market commentary is negative
Trader behaviour is upbeat and invest in more risky assets	Traders stay away from risk-on assets and navigate to more risk-off assets.

Factors that drive Risk-on Risk-off

Diversification: Incorporates an assortment of investments as part of a portfolio. The aim is to minimise risk or volatility by investing in a wide variety of instruments, asset classes, industries and markets.

Asset allocation: The process of dividing your investments into different assets – such as stocks, bonds and cash. When it comes to RORO in investing, asset allocation may be a useful strategy to use.

Risk management techniques: Developing a robust and effective risk management plan can help inform you about the potential risks and with risk-on and risk-off investing. Then you can use tools like stop loss orders and limit orders to protect yourself in volatile markets.

Market timing: The act of moving investments in or out of a financial market, or switching between asset classes, based on predictive methods. If investors can forecast that a market will go up and down, they can make trades to return that market move into a profit.

Conclusion

As risks in the markets increase, investors will jump from risky assets to low-risk assets, such as gold and this is typically described as a risk-off situation. However, when the market is buoyant and optimistic, traders may start to invest in more riskier assets, such as stocks and this is defined as a risk-on strategy.

Risk-on environments are defined by more optimism from central banks, corporate earning results from companies are positive, and market commentary is upbeat. Risk-off, is defined by negative reports from central banks, corporate earnings reflect a poor outlook and market commentary is less than positive.

Knowing and understanding RORO is very important for every trader, you should also know your risk tolerance, knowledge of the markets and have a trading strategy in place. Remember, that markets can go up and down, and never trade more money than you can afford to lose.