Risk-On vs Risk-Off: Understanding the Two Portfolio States

Risk-on and risk-off are the two fundamental states that every tactical allocation strategy alternates between. During risk-on periods, the portfolio holds growth-oriented assets — equities, high-yield bonds, real estate, commodities — that offer higher expected returns but carry meaningful drawdown risk. During risk-off periods, the portfolio shifts to capital-preserving assets — government bonds, Treasury bills, cash equivalents — that offer lower returns but protect against the losses that risk-on assets are experiencing.

What Triggers Risk-Off

Different strategies use different signals to determine when to shift from risk-on to risk-off:

• Momentum signals — asset returns fall below a threshold (absolute momentum) or below the risk-free rate
• Trend filters — asset prices fall below their moving average
• Canary signals — sentinel assets show deteriorating momentum
• Breadth signals — a growing number of assets across the universe enter downtrends
• Macro signals — economic indicators like unemployment or industrial production signal recession
• Layered signals — multiple of the above must agree simultaneously

The specific trigger determines the strategy's character: faster signals (canary, momentum) produce more frequent regime changes and higher turnover; slower signals (macro, layered) produce fewer, higher-conviction regime changes.

What Risk-Off Looks Like

The defensive allocation during risk-off periods varies significantly across strategies. Some hold a single fixed defensive asset — GEM uses aggregate bonds (AGG), ADM uses long-term Treasuries (TLT). Others dynamically select the best-performing defensive option — BAA-B chooses among 7 safe-haven assets, ADM-IP compares TLT vs TIP. Still others default to cash equivalents — LAA uses short-term Treasuries (SHY).

The choice of defensive asset matters enormously. During the 2022 rate shock, strategies using long-term bonds for defense suffered alongside equities. Strategies with adaptive defense (choosing between bonds, cash, and TIPS based on which was performing best) protected far more effectively.

The Time Spent in Each State

Different strategies spend very different proportions of time in each state. Conservative strategies like BAA-B spend roughly 60% of months in risk-off mode due to their sensitive canary triggers. Aggressive strategies like LAA spend less than 15% in risk-off because their macro triggers fire only during genuine recessions. Buy-and-hold portfolios spend 0% in risk-off — they remain fully invested always.

The proportion of time spent in each state is one of the most important characteristics for matching a strategy to an investor's risk tolerance and objectives.