Risk On in the Stock Market - Investment Guide - SmartAsset

Stock market investing is often about following trends. Traders, investors and analysts often try to gauge investor sentiment to understand which direction the winds are blowing so that they can profit from them. A “risk-on” environment indicates that investors are more comfortable taking risks in their portfolios. In this article, we’ll define risk-on investing, identify assets that are affected by it and how to tell when sentiment is changing.

A financial advisor can help you perceive and correctly interpret investor sentiment changes.

What Is a Risk-On Environment?

A risk-on environment describes when investors are willing to invest in higher-risk securities. They feel that corporate profits, economic outlook, accommodative central bank policies and other factors have created a positive environment for investors. While there is always an inherent risk in stock market investing, risk-on investing indicates that investors feel that there is less risk in the market.

When this situation occurs, investors tend to overweight their portfolios towards stocks, invest in riskier companies and avoid rebalancing. Investors may also tend to ignore the warning signals of a change in sentiment because of their euphoria and “paper profits.” This leads to the all-too-common situation of “buying high and selling low” that dooms many investors’ performance.

Classes Affected by Risk-On Sentiment

Not all investment types carry the same risk. While most investments increase in value during a risk-on environment, some do better than others due to their cyclical nature. During a risk-on market, investors may sell bonds and invest in stocks to participate in the overall growth of the market. Additionally, they may seek out higher-risk investments within asset classes that perform better in risk-on environments, such as:

Stocks with higher price-to-earnings ratios
Emerging market stocks or indexes
High-yield bonds
Industrial metals
High-yield currencies (Australian dollar, Canadian dollar)
Crude oil

Risk-On vs. Risk-Off

The alternative to a risk-on environment is called “risk-off.” This happens when investors are reducing risk and investor sentiment turns bearish. Investors start selling risky assets and focus on protecting their assets.

Risk-off scenarios typically happen during a recession, when stock market volatility increases or when war or terrorist attacks happen. Investors shift their portfolios into a “defensive” position and buy these types of investments in their portfolios:

Government bonds
AAA-rated corporate bonds
Low-interest currencies (U.S. dollar, Japanese yen, Swiss franc)
Utility stocks
Money market funds
Gold

How to Tell When Investor Sentiment Is Changing

It’s easy to see the uptrend in a risk-on environment as the stock market continues to rise and set new all-time highs. More and more investors buy stocks and other high-risk investments due to FOMO and the desire for profits. The trick is knowing when investor sentiment starts to change so that you can be ahead of the market when making your investment decisions. Nobody has a crystal ball that consistently allows him to perform better than the market, but you can pay attention to warning signs that will influence your decisions.

Prices of gold rise dramatically. Investors see gold as a safe haven. Rising gold prices often indicate a flight to safety.
Bond yields decrease. Prices of bonds and yields move in opposite directions. Higher demand for bonds leads to an increase in price. Yields decrease when prices go up.
High-Low Index. How many stocks are trading at 52-week highs? When the index is below 30, stocks are trading near their lows and the market is bearish. Above 70 indicates stocks are trading towards highs and are bullish. Dramatic changes in this index could indicate a shift in mindset.
Moving Averages. When the 50-day moving average crosses below the 200-day moving average, that’s known as the “death cross” and suggests prices are headed lower.
The VIX. This volatility index is also known as the “fear index.” A rising VIX indicates an increased need to protect against risk and volatility.
Put / Call Ratio. Investors who think the market will increase typically buy calls. They buy puts when they believe the stock price will go down. When the volume of calls is greater than the puts, this indicates a surplus of optimism. The more that the ratio trends to calls, the higher the risk is in the market.

How to Profit From a Risk-On Environment

These indicators typically are not accurate enough to base your investing decisions upon. However, when you monitoring all of them for changes, this may give you a heads up on changing investor sentiment.

As more indicators trend bearish, it may be a good signal for you to minimize risk and shift towards protecting your assets. When more indicators turn bullish, you may feel more comfortable increasing your risk with a risk-on strategy.

None of these measures is foolproof, but changes should alert you to analyze your holdings and make appropriate investing decisions. As the risk-on sentiment begins to change, you may consider:

Rebalancing your portfolio (“buy low, sell high”)
Target new investments towards underperforming assets
Continue to dollar-cost average into your portfolio strategy
Pare down high-risk assets
Increase your liquidity so you can buy distressed assets during a downturn

The Bottom Line

Over long periods of time, the stock market tends to increase in value. However, during the short term, there are periods of bearish and bullish behaviors. “Stock-on” markets are when bullish sentiment is increasing as investors feel more comfortable going out on the risk spectrum. Investors can profit from market performance during these periods, but it is a good idea to monitor for changes in investor sentiment.

Tips on Investing

Working with a financial advisor can help remove the emotions of investing and help investors focus on the fundamentals of individual investments. Advisors work with investors to develop a strategy and ensure that you stick with it through all market scenarios. Finding an advisor doesn’t have to be hard. SmartAsset’s matching tool can connect you in just minutes with several in your area. If you’re ready, get started now.
Our asset allocation calculator will help you determine the right balance of stocks, bonds and other assets in your portfolio. Answering a few simple questions, we will help us tailor your portfolio allocations to align with your risk tolerance, age and goals.