In reading about investments, you've probably encountered the term "risk premium" and wondered what this nerdy-sounding financial jargon means. Well, it has vital meaning – not just for finance nerds but for all investors.
Underlying this term are concepts that you should apply to all of your investing decisions. Risk premium refers to the higher return you hope to get for taking greater risk than you would with lower-risk investments.
You've also probably seen or heard the term "risk-free rate of return." This refers to returns on investments that hold little or no risk, such as U.S. government bonds or certificates of deposit (which are federally insured). The risk premium is the additional return you may get over the risk-free rate of return. Otherwise, why take the extra risk? Why not just get the same or better return with lower risk?
Then there's "risk-adjusted return," which involves various quantitative methods to rate investments on their returns relative to their risk.
Because you're probably not a finance nerd, you're doubtless looking for simpler ways to compare the risks/returns of different investments.
When the financial services industry talks about projected or expected returns, you'll notice, it doesn't like to talk about not getting them. But the plan is to get them, and it's your job as an investor to estimate or project an investment's likely returns over a period of months or, preferably, years. (If you trade too frequently, you'll be buffeted about by price fluctuations triggered by computerized flash trading , and won't have any way of assessing – much less getting – real value creation over time.)
The potential returns you might expect – if you've done your homework properly -- should justify the risks you take, measure for measure. The important thing is that you understand the risks you're taking and are aware of lower-risk alternatives – and use this information to make the best choices.
Understanding this concept is one thing, but applying it to routine investment decisions is quite another.
In vetting any investment, always consider where it falls along the risk spectrum. On the low end of the risk spectrum are U.S. government bonds, certificates of deposit and money markets, followed in ascending risk levels by corporate bonds, then U.S. stocks, then foreign stocks, then emerging-market stocks, and finally, at the outer limit of risk, venture capital.
Investors need to line up risk and return of different investments and make objective comparisons. For example, you have $10,000 to invest, and two banks are offering two-year CDs, one paying 1 percent and another paying 1.2 percent. Both of these investments are essentially risk-free. The choice is clear: You want the higher-return investment because both carry the same amount of risk — virtually none.
Making such comparisons is often much harder, of course, because most investments do not line up so neatly. For example, if you're thinking about Apple, do you buy Apple stock or an Apple bond? Again, let's assume you have $10,000 to invest. With an Apple bond, you'd be lending Apple money for a fixed period of time, and you know what the return would be. Because the company's finances are rock solid (they have a great deal of cash and earn a lot of money currently), the risk is quite low, and Apple bonds offer a low return.