The risk-free rate is what you can earn without taking any market risk — in practice, the yield on a short-term US Treasury bill. It is the bar every other investment has to clear: if a stock cannot beat it, you were not paid for the risk you took.
You always have the option of lending money to the US government for a few months and getting it back with interest. That interest carries about as little default risk as anything in finance, because the government can print the dollars it owes you. So it is the floor. Any investment that carries risk — a stock, a corporate bond, a rental property — has to offer MORE than the floor, or nobody rational would hold it instead of the T-bill.
The extra return above the risk-free rate has a name: the excess return, or risk premium. It is the only part of your return you actually got PAID for taking risk, and it is what the standard risk-adjusted metrics measure. The Sharpe ratio divides excess return by volatility; the Sortino ratio divides it by downside volatility only. Both start by subtracting the risk-free rate, because a return you could have had for free does not count as compensation for risk.
Example (illustrative): suppose T-bills yield 4% and a stock returns 6% over the year with a lot of turbulence along the way. The raw return looks positive, but the excess return is only 2% — you took a year of volatility to earn two percentage points more than doing nothing risky. Whether that was a good trade depends entirely on how bumpy the ride was, which is exactly the question Sharpe answers.
When the risk-free rate rises, the bar rises for every asset at once. A high-growth stock whose value rests on profits far in the future is hit hardest, because those future profits are now discounted against a higher guaranteed alternative. This is a large part of why rate expectations move the whole market together, and why the same company can be worth noticeably less on a day when nothing about the company changed. It also feeds sector rotation: money moves out of long-duration growth and into sectors whose cash flows arrive sooner.
The risk-free rate says nothing about whether any particular stock is a good buy. It is a benchmark, not a signal — it tells you what the alternative pays, and leaves the judgement to you. It is also only nominally risk-free: if inflation runs at 5% and your T-bill pays 4%, you lost 1% of real purchasing power with perfect certainty. None of this is investment advice.
Most commonly the yield on a short-dated US Treasury bill (often 3-month) for short horizons, or the 10-year Treasury note for long-horizon valuation work. Both are published daily by the US Treasury, so the number is public and checkable.
It is free of default risk — the US government is assumed to always repay. It is not free of inflation risk: if prices rise faster than the yield, you lose real purchasing power even though you got every dollar you were promised.
Because return you could have earned with no risk is not compensation for risk. Subtracting it isolates the excess return — the part you were actually paid for taking uncertainty on.
Browse all S&P 500 tickers to see this metric applied to individual companies.
Educational research only — not investment advice.