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 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 rates 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.
The key is to know the risk levels of different investments and to act according to your particular risk tolerance.
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. The potential returns you might expect — if you’ve done your homework properly — should justify the amount of risk you take.
What’s important 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, consider where it falls along the risk spectrum. On the low end 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. If you’re thinking about Apple, do you buy Apple stock or an Apple bond? 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 more than $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 with little risk.
There is no way to know how much Apple stock will rise, if at all. So you must try to project based on anticipated market conditions plus what you believe about Apple’s future earnings growth. This is no easy task.
In calculating your expected return on investment, you face a dizzying array of variables: dividends, dividend growth, earnings, earnings growth, stock buybacks, currency values, inflation, etc.
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 investments and to act according to your risk tolerance.
If your risk tolerance is average, you probably won’t be comfortable investing much in something high-risk. But if you want some potentially high returns, you might buy a small piece, limiting the risk to your overall portfolio.
Your goal shouldn’t only be to know your investments but to know yourself — and to thine own risk tolerance be true.
Ted Schwartz, a certified financial planner, is president and CEO of Capstone Investment Financial Group, advising investors and endowments. He brings insights into personal motivation when advising clients on achieving their wealth management goals. Schwartz can be reached at firstname.lastname@example.org.