A risk-free asset has a certain future return. Treasuries (especially T-bills) are considered to be risk-free because the U.S. government backs them. Because they are so safe, the return on risk-free assets is very close to the current interest rate.
Many academics say that there is no such thing as a risk-free asset because all financial assets carry some degree of risk. Technically, this may be correct. However, the level of risk is so small that, for the average investor, it is appropriate to consider U.S. Treasuries or Treasuries from stable Western governments to be risk-free.
Breaking Down Risk-Free Asset
While the return on a risk-free asset is known, this does not guarantee a profit in regards to purchasing power. Depending on the length of time until maturity, inflation can cause the asset to lose purchasing power even if the dollar value has risen as predicted.
When an investor takes on an investment, there is an anticipated return rate expected depending on the duration the asset is held. The risk is demonstrated by the fact that the actual return and the anticipated return may be very different. Since market fluctuations can be hard to predict, the unknown aspect of the future return is considered to be the risk. Generally, an increased level of risk indicates a higher chance of large fluctuations, which can translate to significant gains or losses depending on the ultimate outcome.
Risk-free investments are considered to be reasonably certain to gain at the level predicted. Since this gain is essentially known, the rate of return is often much lower to reflect the lower amount of risk. The expected return and actual return are likely to be about the same.
For a long-term investment to continue to be risk-free, any reinvestment necessary must also be risk-free. In this regard, the exact rate of return may not be predictable from the beginning for the entire duration of the investment.
For example, if a person invests in six-month Treasury bills, the rate of return on the initial Treasury bill that was purchased may not be equal to the rate on the next Treasury bill purchased as part of the six-month reinvestment process. In that regard, there is some risk over the long term, since the rates may change between each instance of reinvestment, but the risk of achieving each specified returned rate for the six months covering a particular Treasury bill's growth is essentially guaranteed.