What Investors Must Know About Risk and Return

What return would you expect on Apple stock? It has been wildly volatile, dropping from over $700 per share to under $400 within the past year. Your return from Apple stock will contain two elements: the dividend and the appreciation or decline in stock price. The dividend is currently almost 3 percent -- not much less than 30-year bonds, which are virtually risk free. There is no way to know how much Apple stock will rise, and it could fall. So you must try to project this based on anticipated market conditions plus what you believe about Apple's future earnings growth. This is no easy task.

Another example: Stock A and stock B are both currently selling at $15 per share and pay no dividends. Stock A is earning $1 per share, so it has a current price/earnings (P/E) ratio of 15. Stock B is earning 75 cents per share, so it has a P/E of 20.

Should you buy stock A? What if you learned that the expected earnings growth of stock A for the next five years is zero and of stock B, 20 percent per year? From that information, you could calculate how much you would expect to earn as a shareholder of each stock over the next five years. Naturally you have to decide how much you trust these projections.

In calculating your expected return on investment, you're confronted with a dizzying array of variables. These include dividends, dividend growth, earnings, earnings growth, stock buybacks, currency values, inflation and on and on.

The risk spectrum is helpful in guiding decisions, but it has some fuzzy parts. For example, U.S. stocks are generally considered to hold less risk than those in emerging markets – but not always, so you might be tempted to position for sky-high emerging market returns. Yet, you have to consider political risk, which you don't worry about with U.S. stocks. A regime change could push your companies out of government favor and out of business.

The best returns come with more risk, but this same risk can mean you get no returns at all or even lose invested capital. So goes the paradox of risk premiums. The key is to know the risk levels of different types of investments and to act according to your particular risk tolerance.

If your risk tolerance is average, you probably won't be comfortable investing much of your portfolio in something high-risk, like a venture capital fund. But if you want some of the potentially high returns from such investments, you might buy a small piece, limiting the risk to your overall portfolio.

Your goal shouldn't only be to know your investments but also to know yourself – and to thine own risk tolerance be true.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

Ted Schwartz, a certified financial planner, is president and chief investment officer of Capstone Investment Financial Group. He advises individual investors and endowments, and serves as the adviser to CIFG UMA accounts. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation when advising clients on how to achieve their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at ted@capstoneinvest.com.

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