What Investors Must Know About Risk and Return

Sept. 24, 2013 — -- 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.

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.