Risk is like a switch. Or, at least in the investment world, it can be helpful to think of risk as sort of like a dimmer switch. It slides between the “On” and “Off” positions depending on the investment setting and how much risk tolerance is out there.
When risk gets turned on, it tends to be at a time when the investment landscape feels less risky, so investors turn to investments that are perceived to be higher risk (like stocks) to satiate their appetites. We call this “Risk On.” However, when things start to feel riskier, the switch gets flipped off, and investors gravitate toward lower-risk investments (like bonds). We call this “Risk-Off.”
Our featured indicator above puts some meat on the bones of this concept. It utilizes something called the Risk-On/Risk-Off Diffusion Index. In a nutshell, it takes a bunch of assets that tend to go up when global stocks go up and combines them into an index called the Risk-On Index. These are assets like high-yield (junk) bonds, crude oil, large-cap cyclical stocks, technology stocks, palladium, and the South African Rand. It then does the same thing but for assets that tend to go up when global stocks go down. These are assets like frontier market stocks, the Swiss Franc, consumer staples stocks, the Japanese Yen, long-term Treasury bonds, and utilities stocks. These comprise the Risk-Off Index.
Each index has a reading between 0% and 100%, determined by whether the assets in the index are trading above or below their respective 200-day average closing price. When we subtract the Risk-Off Index from the Risk-On Index, we get an overall reading for the combined diffusion index that can vary between -100 and 100. The closer the number is to 100, the further the switch is to the full “On” position and vice versa.
The overall reading is shown in the bottom clip of the chart above (orange line). It started falling at the beginning of 2020, as global risk appetites fell heading into the pandemic-induced sell-off in March. But then it reversed as global risk-taking recovered and risk assets rallied. It hovered at high levels for most of this year. But, as you can see, it has plummeted again in recent weeks, a sign that global risk appetites are abating.
Historically, readings above 50 have corresponded with above-average gains in the MSCI All Country World Index (a benchmark measure for global stocks). However, readings between 50 and -35 have resulted in more average global stocks returns, around 7% per annum. And when the reading falls below -35, as it’s presently close to doing, global stock returns have actually been negative on a per annum basis, averaging around -7.75%.
So, the main takeaway from this indicator is that investor’s risk appetites rise and fall over time, like a wave or a dimmer switch. Investors become more likely to invest in higher-risk assets when risk is perceived as low and vice versa. When these risk preferences change, some assets tend to perform better than others. By measuring the technical performance of these assets, we can use the result to gauge whether investors perceive the current environment as being Risk-On or Risk-Off. This, in turn, helps us determine whether the return-to-risk tradeoff is favorable for stocks at any given moment.
This is intended for informational purposes only and should not be used as the primary basis for an investment decision. Consult an advisor for your personal situation.
Indices mentioned are unmanaged, do not incur fees, and cannot be invested into directly.
Past performance does not guarantee future results.