Always write down the reasons, pro and con, before making a purchase or a sale

Tip to the Investors:  Always Write it Down

Writing down your reasons for making an investment should save you in your investing.

What you expect to make?
What you expect to risk?
The reasons why?

Always write down the reasons, pro and con, before making a purchase or a sale.

• Major successes in some investors were invariably preceded by a type of written analysis.  
• Sudden emotional decisions have generally being disappointments.
• Writing things down before you do them can keep you out of trouble.  
• It can bring you peace of mind after you have made your decision.
• It also gives you tangible material for reference to evaluate the whys and wherefores of your profits or losses.

Quality Not Quantity

I have seen many analyses, some involving many pages of information.

In practice, quantity doesn't make quality.  

There is invariably one ruling reason why a particular security transaction can be expected to show profit.

• Writing it down will help you find it.
• It will help you judge whether it is really as important as your first inclination suggests.

Are you buying just because something "acts well"?

Is it a technical reason - 

• a coming increase in earnings or dividend not yet discounted in the market price, 
• a change of management,
• a promising new product, 
• an expected improvement in the market's valuation of earnings?

In any given case you will find that one factor will almost certainly be more important than all the rest put together.



Reward/Risk Ratio

Writing it down will help you estimate what you expect to make and it is important that this be worthwhile.

Of course, you will want to decide how much you can afford to lose.

There will be a level at which you will decide that things have not worked out and where you will sell.

Your risk is the difference between your cost and this sell point; it ought to be substantially less than your hopes for profit.

You certainly want to feel that the odds as you see them are in your favour.



Much More Difficult:  When to Sell

All this self-interrogation will help you immeasurably in the much more difficult decision:  when to close a commitment.

When you open a commitment, whether it is a purchase or a short sale, you are, so to speak, on your home ground.  Unless everything suits you, you don't play.

But when you are called upon to close a commitment, then you have to make decisions, whether you see the answer clearly or not (analogy:  being stuck on a railway crossing with the train approaching).

• You don't know what to do -but you have to do something.  
• Go backward, go forward - or jump out.

If you know clearly why you bought a stock it will help you to know when to sell it.  

• The major factor which you recognized when you bought a security will either work out or not work out.  
• Once you can say definitely that it has worked or not worked, the security should be sold.

One of the greatest causes of loss in security transactions is to open a commitment for a particular reason, and then fail to close it when the reason proves to be invalid.

• Write it down and you will be less likely to find yourself making irrelevant excuses for holding a security long after it should have been sold.
• Better still, a stock well bought is far more than half the battle.

Investments and Risk Reward Ratio

It is always interesting that there are so many different types of investments around us, ranging from regulated investments such as bonds and stocks, all the way to unregulated investment vehicles such as collectibles, antiques and many others. In this post, I’m slightly more inclined to talk about some common investments, mainly money markets, bonds, stocks and derivatives as well as their risk-reward relationships. To illustrate this, let’s start with a picture.

I do hope that the picture is pretty clearcut. Basically, it says that the higher the return, the higher the risk. Note that in the picture, derivatives has lower return, but higher risk and I will explain why it is so in the picture. I am actually taking into account expected rewards, which is different from potential rewards. Potential rewards mean the high end spectrum of what is achievable, whereas expected rewards basically mean the aggregate returns of all investors who participate in the investing of the instrument.

Now, after having explained my definition, let’s look at the investments and their risk rewards ratio. It is seen from the diagram that for taking more risk, the expected rewards is greater, with the exception of derivatives. The explanation is that derivatives are theoretically zero sum games, which means that when someone makes money, another has to lose it. After commissions, spreads and other charges, they are practically negative sum games.

I have friends who said that stock markets are negative sum games too, because the same principle applies. However, they missed an important point, which is the fact that wealth is created through the stock market and the evidence is in the issuance of dividends. For example, I bought a stock at $10 and sell it for $9.50. I may seem to have lost money, but what if I got a dividend payout of $1.00 while holding the stock? From this example, we can see that the purchase of stocks is not a zero sum game and that the general direction of the stock market in the long run is an uptrend. Of course, I am assuming that there is no large scale war or natural disaster that will destroy a significant amount of wealth. Even if there is though, wealth will be recreated as long as humans survived.

Just like stocks, bonds and money markets are also both not zero sum games, since there is an effective yield that you can get. While some of them may default their payments, we are looking at the aggregate of all investments in the instrument, which makes it a positive sum game.

For derivatives though, it is a clear cut zero sum game, because there is absolutely no payouts linked to the instrument. You don’t get dividends for holding options or futures. However, I would like to argue from another standpoint that perhaps it is not really that much of a zero sum game. The reason I would like to input this perspective is the prevalence of people who like to hedge their investments. Therefore, they may have holdings of stocks and buying options to offset the downside. Hedging in such a way often gives them an effective yield almost equilvalent to the risk-free rate. Therefore, they may not care if their derivative products lose money, since their overall portfolio gives them the desired return that they want.

This seems to get quite complicated, but I am suggesting that if there are really quite a number of hedgers out there in the financial world, it is possible that they are all holding the derivatives that lose money. Consequently, this may mean that it may be slightly easier to profit from derivatives than a strict zero sum game, since some people participate in the game without the intention of winning. Of course, if we aggregate all the positions, we are still back to a strict zero sum game. 

However, my purpose in this post is only to bring about another perspective that perhaps not everybody wants to make money from every market. Some people may participate in some markets and lose constantly but still persist because they satisfy them in some other way. Therefore, it may mean that for those who are serious about making money in the markets, the chances are slightly higher. After all, it is easier to win in a race against leisure runners than national runners who are committed to getting that next medal.

Of course, with everything said, it’s just my hypothesis and it may or may not be right. 

http://www.firstmillionchallenge.com/investments-and-risk-reward-ratio/


This article was first posted on 24.11.2011.

"No risk, no reward." "Higher risk, higher returns."

Risk:  The probability and value of financial loss.

Specific risk:  Risk that is associated with an individual investment.

Old cliche in finance:  "no risk, no reward".

But there is absolutely no reason to think that accepting risk inherently generates financial returns.  

The reality is the opposite:  all other things being equal, higher risk causes you lower financial gain, since the costs you incur as a result of the elevated risk corrode the value of your assets.

All other things being equal between two distinct investment options, if one option has greater risk, then the organisation selling that investment must offer a higher rate of return in order to attract investors.

It is not that the higher risk causes higher returns - it is that investors demand higher returns in order to accept the higher risk.


Various models are used to understand the relationship between risk and returns:

1. CAPM
2. APT
3. Value at Risk
4. Expected Shortfall
5. Ratings by underwriting agencies

Evaluating Quality first, then Price. Fair price is one associated with adequate return at acceptable risk.

1.   The most important task in buying a stock is to determine that the company is a good company in which to own stock for the long term.  (QUALITY)

2.  However, no matter how good the company, if the price of its stock is too high, it is not going to be a good investment.

3.  A stock price must pass two tests to be considered reasonable:
(i)  The hypothetical total return from the investment must be adequate - enough to contribute to a portfolio average of around 15% - sufficient to double its value every 5 years.  (REWARD).
(ii)  The potential gain should be at least 3x the potential loss.  (RISK)

4.  To complete these tasks, you have to have learned how to do the following:
(i)  Estimate future sales and earnings growth.
(ii)  Estimate future earnings.
(iii)  Analyze past PEs (Check the current PE with the average past PEs)
(iv)  Estimate future PEs.
(v)  Forecast the potential high and low prices.
(vi)  Calculate the potential return.
(vii)  Calculate the potential risk.
(viii)  Calculate a fair price.

5.  If you take each of these steps in 4(i) to 4(viii), cautiously and shun excesses, your actual results is likely to be as good or better than the forecast at least four out of the five times.

6.  And you will have a track record to rival any professional.

That's all folks!

To Buy or Not to Buy: Quality first, then Potential Return at an Acceptable Risk.

To buy or not to buy - the bottom line is the potential reward and the amount of risk that you must accept to achieve it.

Always assuming you have done your due diligence concerning the quality issues, look to see if the hypothetical total return is sufficient to warrant adding the stock to your portfolio.  If the stock appears to be capable of doubling its value in five years, it's probably a good buy.

If you have been cautious enough in your estimates of earnings growth and future PEs, and if the potential reward is at least 3x the risk of loss, you'll have no qualms about buying the stock.



Use Your Common Sense

Investing is far from a precise science.

What you lose in accuracy because you are building one estimate upon another, you gain by being conservative in your estimates.

If you are careful to take the more cautious choice at every opportunity, you are rarely going to be disappointed at the outcome.

A small difference - a 1% difference in the risk would translate into only a small difference in the share price - is not enough to warrant waiting for the price to be just right.

If the price is more than just a little too high for the value parameters to satisfy you, however, you'll want to complete your study and wait for the price to come down to a more reasonable figure.



Summary:

1.  Always the Quality criteria must be met first
2.  Then look at the Total Return - this must be >15% per year.
3.  Only buy when the Risk is acceptable, that is, the potential reward must be at least 3x the risk of loss.
4.  Don't squabble over pennies when you are buying.

REMEMBER:  Prices can fluctuate by as much as 50% on either side of their averages during the course of the year; so you might be pleasantly surprised when a price you thought beyond hope just happens to materialize one day.

When evaluating the price, look at the potential return and the risk you must take to get that return.

When it comes to evaluating the price of a stock, you're really interested in just 2 things:

1.  The potential return, and
2.  The risk you must take to get that return.

If the potential return is worth the risk, the price is right.

If it is not, you can simply wait until it is.

As volatile as the stock market is, most stocks will sell at a favourable price sometime during the year.

To estimate the potential return, you will have to come up with a reasonable forecast of how high the price might go.  Knowing the hypothetical potential high price, you can estimate the potential return.

To evaluate risk, you will need to conservatively estimate the stock's potential lowest price.  If your potential gain is at least three times as much as you risk losing, your stock is probably selling at a fair price.



For example:

Stock TUW

Potential high price = $20
Potential low price = $10
Market price = $12

Potential gain = $20 - $12 = $18
Potential loss = $ $12 - $10 = $2
Therefore, potential gain : potential loss = $8 : $2 = 4 : 1

As the potential gain is at least 3x as much as you risk losing, the stock is probably selling at a fair price.

Understanding Risk and Return tradeoff

The relationship of risk and potential reward in stock investing is often misunderstood in shaping an investment strategy.

There is no investing in stocks without risk and there is no return without risk.

If you are adverse to the idea of taking any amount of risk, then stocks are not for you.

It will be more difficult (but not impossible) for you to reach your financial goals without investing in stocks.


Understanding Risk

Risk is the potential for your investment to lose money, for a variety of reasons - meaning your stock's price will fall below what you paid for it.

No one wants to lose money on an investment, but there's a good chance you will if you invest in stocks.

The rule of thumb is "the higher the risk, the higher the potential return, and the less likely it will achieve the higher return."

Buying a stock that is risky doesn't mean you will lose money and it doesn't mean it will achieve a 25% gain in one year. However, both outcomes are possible.

How do you know what the risk is and how do you determine what the potential reward (stock price gain) should be?


Measuring risk against reward

When you evaluate stocks as potential investment candidates, you should come up with an idea of what the risks are and how much of a potential price gain would make the risks acceptable.

Calculating risk and potential reward is as much an art as it is a science.

You need to understand the principle of risk and reward to make an educated investment as opposed to a guess.

The most common type of risk is the danger your investment will lose money.

You can make investments that guarantee you won't lose money, but you will give up most of the opportunity to earn a return in exchange.

When you calculate the effects of inflation and the taxes you pay on the earnings, your investment may return very little in real growth.


Will I achieve my financial goals?

If you can't accept much risk in your investments, then you will earn a lower return.

To compensate for the lower anticipated return, you must increase the amount invested and the length of time it is invested.

Many investors find that a modest amount of risk in their portfolio is an acceptable way to increase the potential of achieving their financial goals.

By diversifying their portfolio with investments of various degrees of risk, they hope to take advantage of a rising market and protect themselves from dramatic losses in a down market.

The elements that determine whether you can achieve your investment goals are the following:
1. Amount invested
2. Length of time invested.
3. Rate of return or growth
4. Fewer fees, taxes, and inflation.


Minimize risk - Maximize reward

The MOST SUCCESSFUL INVESTMENT is one that gives you the most return for the least amount of risk.

Every investor needs to find his or her comfort level with risk and construct an investment strategy around that level.

A portfolio that carries a significant degree of risk may have the potential for outstanding returns, but it also may fail dramatically.

Your comfort level with risk should pass the "good night's sleep" test, which means you should not worry about the amount of risk in your portfolio so much as to lose sleep over it.

There is no "right or wrong" amount of risk - it is a very personal decision for each investor.

However, young investors can afford higher risk than older investors can because young investors have more time to recover if disaster strikes.

If you are 5 years away from retirement, you don't want to be taking extraordinary risks with your nest-egg, because you will have little time left to recover from a significant loss.

Of course, a too-conservative approach may mean you don't achieve your financial goals.

The higher the risk, the higher the potential return, and the LESS LIKELY it will achieve the higher return

UNDERSTANDING RISK

The rule of thumb is "the higher the risk, the higher the potential return," but you need to consider an addition to the rule so that it states the relationship more clearly:  the higher the risk, the higher the potential return, and the less likely it will achieve the higher return.

Buying a stock that is risky doesn't mean you will lose money and it doesn't mean it will achieve a 25% gain in one year.  However, both outcomes are possible.

How do you know what the risk is and how do you determine what the potential reward (stock price gain) should be?

Good quality company but trading at high price - Add this to your "watch list."

If the price is too high, you should add the company to your "watch list."  You have found the company to be a good quality company but the price is too high.  If it's much too high, put it on your "watch list" and wait for it to come down.

In rare circumstances, you may wish to put in a market order; but you will not want to do this in every case.

The "buy price" is the price at which both your risk and reward criteria are met.  This is the highest price you can pay and realize both a Total Return that will double your money every five years and where the risk of loss is less than one third of the potential gain.

The reward should be at least three times the risk.  Even though you may sometimes accept a total return of less than 15% because of the contribution that the stock can make to your portfolio's stability, you don't want to accept a Risk index of much above 25%.

If the Risk index is zero or negative, you should question your assumptions about the quality issues.  You will want to question why the price of the stock is so low.  What do others know about the company that you don't know?  If you're a new investor, you should move on to another candidate.  If you can satisfy yourself that the price is depressed for no good reason, then you can be a contrarian and buy the stock.


Additional note:

Definition of 'Market Order'

An order that an investor makes through a broker or brokerage service to buy or sell an investment immediately at the best available current price. A market order is the default option and is likely to be executed because it does not contain restrictions on the buy/sell price or the timeframe in which the order can be executed.

A market order is also sometimes referred to as an "unrestricted order."

Investopedia explains 'Market Order'

A market order guarantees execution, and it often has low commissions due to the minimal work brokers need to do. Be wary of using market orders on stocks with a low average daily volume: in such market conditions the ask price can be a lot higher than the current market price (resulting in a large spread). In other words, you may end up paying a whole lot more than you originally anticipated! It is much safer to use a market order on high-volume stocks.

Read more: http://www.investopedia.com/terms/m/marketorder.asp#ixzz2FjYO8xoI



Calculating the Risk Index

Risk Index
= (Current Price - Potential Low Price) / (Potential High Price - Potential Low Price)

The result is the risk index, the percentage of the deal that is risk.
We look for a risk index of 25 percent or less, meaning that only a quarter of the proposition or less is risk.
We would then have at least 75 percent to gain versus at most 25 percent to lose; so the reward is at least three times the risk.

7 investment risks and how to deal with them

The fact is that you cannot get rich without taking risks. Risks and rewards go hand in hand; and, typically, higher the risk you take, higher the returns you can expect. In fact, the first major Zurich Axiom on risk says: "Worry is not a sickness but a sign of health. If you are not worried, you are not risking enough". Then the minor axiom says: "Always play for meaningful stakes".

The secret, in other words, is to take calculated risks, not reckless risks.

In financial terms, among other things, it implies the possibility of receiving lower than expected return, or not receiving any return at all, or even not getting your principal amount back.

Every investment opportunity carries some risks or the other. In some investments, a certain type of risk may be predominant, and others not so significant. A full understanding of the various important risks is essential for taking calculated risks and making sensible investment decisions.

Seven major risks are present in varying degrees in different types of investments.

Default risk

This is the most frightening of all investment risks. The risk of non-payment refers to both the principal and the interest. For all unsecured loans, e.g. loans based on promissory notes, company deposits, etc., this risk is very high. Since there is no security attached, you can do nothing except, of course, go to a court when there is a default in refund of capital or payment of accrued interest.

Given the present circumstances of enormous delays in our legal systems, even if you do go to court and even win the case, you will still be left wondering who ended up being better off - you, the borrower, or your lawyer!

So, do look at the CRISIL / ICRA credit ratings for the company before you invest in company deposits or debentures.

Business risk

The market value of your investment in equity shares depends upon the performance of the company you invest in. If a company's business suffers and the company does not perform well, the market value of your share can go down sharply.

This invariably happens in the case of shares of companies which hit the IPO market with issues at high premiums when the economy is in a good condition and the stock markets are bullish. Then if these companies could not deliver upon their promises, their share prices fall drastically.

When you invest money in commercial, industrial and business enterprises, there is always the possibility of failure of that business; and you may then get nothing, or very little, on a pro-rata basis in case of the firm's bankruptcy.

A recent example of a banking company where investors were exposed to business risk was of Global Trust Bank. Global Trust Bank, promoted by Ramesh Gelli, slipped into serious problems towards the end of 2003 due to NPA-related issues.

However, the Reserve Bank of India's [Get Quote] decision to merge it with Oriental Bank of Commerce [Get Quote] was timely. While this protected the interests of stakeholders such as depositors, employees, creditors and borrowers was protected, interests of investors, especially small investors were ignored and they lost their money.

The greatest risk of buying shares in many budding enterprises is the promoter himself, who by overstretching or swindling may ruin the business.

Liquidity risk

Money has only a limited value if it is not readily available to you as and when you need it. In financial jargon, the ready availability of money is called liquidity. An investment should not only be safe and profitable, but also reasonably liquid.

An asset or investment is said to be liquid if it can be converted into cash quickly, and with little loss in value. Liquidity risk refers to the possibility of the investor not being able to realize its value when required. This may happen either because the security cannot be sold in the market or prematurely terminated, or because the resultant loss in value may be unrealistically high.

Current and savings accounts in a bank, National Savings Certificates, actively traded equity shares and debentures, etc. are fairly liquid investments. In the case of a bank fixed deposit, you can raise loans up to 75% to 90% of the value of the deposit; and to that extent, it is a liquid investment.

Some banks offer attractive loan schemes against security of approved investments, like selected company shares, debentures, National Savings Certificates, Units, etc. Such options add to the liquidity of investments.

The relative liquidity of different investments is highlighted in Table 1.

Table 1
Liquidity of Various Investments
Liquidity	Some Examples
Very high	Cash, gold, silver, savings and current accounts in banks, G-Secs
High	Fixed deposits with banks, shares of listed companies that are actively traded, units, mutual fund shares
Medium	Fixed deposits with companies enjoying high credit rating, debentures of good companies that are actively traded
Low and very low	Deposits and debentures of loss-making and cash-strapped companies, inactively traded shares, unlisted shares and debentures, real estate

Don't, however, be under the impression that all listed shares and debentures are equally liquid assets. Out of the 8,000-plus listed stocks, active trading is limited to only around 1,000 stocks. A-group shares are more liquid than B-group shares. The secondary market for debentures is not very liquid in India. Several mutual funds are stuck with PSU stocks and PSU bonds due to lack of liquidity.

Purchasing power risk, or inflation risk

Inflation means being broke with a lot of money in your pocket. When prices shoot up, the purchasing power of your money goes down. Some economists consider inflation to be a disguised tax.

Given the present rates of inflation, it may sound surprising but among developing countries, India is often given good marks for effective management of inflation. The average rate of inflation in India has been less than 8% p.a. during the last two decades.

However, the recent trend of rising inflation across the globe is posing serious challenge to the governments and central banks. In India's case, inflation, in terms of the wholesale prices, which remained benign during the last few years, began firming up from June 2006 onwards and topped double digits in the third week of June 2008. The skyrocketing prices of crude oil in international markets as well as food items are now the two major concerns facing the global economy, including India.

Ironically, relatively "safe" fixed income investments, such as bank deposits and small savings instruments, etc., are more prone to ravages of inflation risk because rising prices erode the purchasing power of your capital. "Riskier" investments such as equity shares are more likely to preserve the value of your capital over the medium term.

Interest rate risk

In this deregulated era, interest rate fluctuation is a common phenomenon with its consequent impact on investment values and yields. Interest rate risk affects fixed income securities and refers to the risk of a change in the value of your investment as a result of movement in interest rates.

Suppose you have invested in a security yielding 8 per cent p.a. for 3 years. If the interest rates move up to 9 per cent one year down the line, a similar security can then be issued only at 9 per cent. Due to the lower yield, the value of your security gets reduced.

Political risk

The government has extraordinary powers to affect the economy; it may introduce legislation affecting some industries or companies in which you have invested, or it may introduce legislation granting debt-relief to certain sections of society, fixing ceilings of property, etc.

One government may go and another come with a totally different set of political and economic ideologies. In the process, the fortunes of many industries and companies undergo a drastic change. Change in government policies is one reason for political risk.

Whenever there is a threat of war, financial markets become panicky. Nervous selling begins. Security prices plummet. In case a war actually breaks out, it often leads to sheer pandemonium in the financial markets. Similarly, markets become hesitant whenever elections are round the corner. The market prefers to wait and watch, rather than gamble on poll predictions.

International political developments also have an impact on the domestic scene, what with markets becoming globalized. This was amply demonstrated by the aftermath of 9/11 events in the USA and in the countdown to the Iraq war early in 2003. Through increased world trade, India is likely to become much more prone to political events in its trading partner-countries.

Market risk

Market risk is the risk of movement in security prices due to factors that affect the market as a whole. Natural disasters can be one such factor. The most important of these factors is the phase (bearish or bullish) the markets are going through. Stock markets and bond markets are affected by rising and falling prices due to alternating bullish and bearish periods: Thus:

• Bearish stock markets usually precede economic recessions.
• Bearish bond markets result generally from high market interest rates, which, in turn, are pushed by high rates of inflation.
• Bullish stock markets are witnessed during economic recovery and boom periods.
• Bullish bond markets result from low interest rates and low rates of inflation.

How to manage risks

Not all the seven types of risks may be present at one time, in any single investment. Secondly, many-a-times the various kinds of risks are interlinked. Thus, investment in a company that faces high business risk automatically has a higher liquidity risk than a similar investment in other companies with a lesser degree of business risk.

It is important to carefully assess the existence of each kind of risk, and its intensity in whichever investment opportunity you may consider. However, let not the very presence of risk paralyse you into inaction. Please remember that there is always some risk or the other in every investment option; no risk, no gain!

What is important is to clearly grasp the nature and degree of risk present in a particular case � and whether it is a risk you can afford to, and are willing to, take.

Success skill in managing your investments lies in achieving the right balance between risks and returns. Where risk is high, returns can also be expected to be high, as may be seen from Figure 1.

Figure 1: The Risk-Return Trade-Off

Once you understand the risks involved in different investments, you can choose your comfort zone and stay there. That's the way to wealth.

(Excerpt from Personal Investment & Tax Planning Yearbook (FY 2008-09) by N. J. Yasaswy, published by Vision Books.)

Published by 

http://www.rediff.com/money/2008/jun/24bspec.htm

Related:

The Sources of Risk in Stock Investing

Understanding Risk and Reward relationship

Risk versus Reward

Most investors believe that the more risk you take on, the greater the profit you can expect.

The Master Investor, on the contrary, does not believe that risk and reward are related.  By investing only when his expectancy of profit is positive, he assumes little or no risk at all.

Reward-risk Chart

Everyone will fall on different parts of the below reward-risk graph.  

The goal is to get to the fourth quadrant (high reward, low risk; bottom right hand corner). 




Of course the ideal quadrant is the Low Risk, High Reward quadrant. 
Yet many times, investors end up in the High Risk, Low Reward quadrant.




Always understand the risk-reward relationship in your investments and your work.







     

This strategy is very safe for selected high quality stocks. Margin of Safety Principle

The downside risk is protected through ONLY buying when the price is low or fairly priced.  


Therefore, when the price is trending downwards and when it is obviously below intrinsic value, do not harm your portfolio by selling to "protect your gains" or "to minimise your loss."  


Instead, you should be brave and courageous (this can be very difficult for those not properly wired)  to add more to your portfolio through dollar cost averaging or phasing in your new purchases.  This strategy is very safe for selected high quality stocks as long as you are confident and know your valuation.  It has the same effect of averaging down the cost of your purchase price. 


 However, unlike selling your shares to do so, buying more below intrinsic value ensures that your money will always be invested to capture the long term returns offered by the business of the selected stock.

Concept of Risk vs. Reward

Evaluation of Customers - Concept of Risk vs. Reward

Measuring Portfolio RisksOne of the concepts used in risk and return calculations is standard deviation which measures the dispersion of actual returns around the expected return of an investment. Since standard deviation is the square root of the variance, this is another crucial concept to know. The variance is calculated by weighting each possible dispersion by its relative probability (take the difference between the actual return and the expected return, then square the number).

The standard deviation of an investment's expected return is considered a basic measure of risk. If two potential investments had the same expected return, the one with the lower standard deviation would be considered to have less potential risk.

Risk MeasuresThere are three other risk measures used to predict volatility and return:

• Alpha - this measures stock price volatility based on the specific characteristics of the particular security. As with beta, the higher the number, the higher the risk.
  
• Sharpe ratio- this is a more complex measure that uses the standard deviation of a stock or portfolio to measure volatility. This calculation measures the incremental reward of assuming incremental risk. The larger the Sharpe ratio, the greater the potential return. The formula is: Sharpe Ratio = (total return minus the risk-free rate of return) divided by the standard deviation of the portfolio.
  
• Beta - this measures stock price volatility based solely on general market movements. Typically, the market as a whole is assigned a beta of 1.0. So, a stock or a portfolio with a beta higher than 1.0 is predicted to have a higher risk and, potentially, a higher return than the market. Conversely, if a stock (or fund) had a beta of .85, this would indicate that if the market increased by 10%, this stock (or fund) would likely return only 8.5%. However, if the market dropped 10%, this stock would likely drop only 8.5%.
  
• Learn how to properly use beta to help meet your portfolio's risk criteria in the article, Beta: Gauging Price Fluctuations.

Asset Allocation
In simple terms, asset allocation refers to the balance between growth-oriented and income-oriented investments in a portfolio. This allows the investor to take advantage of the risk/reward tradeoff and benefit from both growth and income. Here are the basic steps to asset allocation:

1. Choosing which asset classes to include (stocks, bonds, money market, real estate, precious metals, etc.)
2. Selecting the ideal percentage (the target) to allocate to each asset class
3. Identifying an acceptable range within that target
4. Diversifying within each asset class

If you are unfamiliar with asset allocation, refer to the tutorial: Asset Allocation.

Risk ToleranceThe client's risk tolerance is the single most important factor in choosing an asset allocation. At times, there may be a distinct difference between the risk tolerance of a client and his/her spouse, so care must be taken to get agreement on how to proceed. Also, risk tolerance may change over time, so it's important to revisit the topic periodically. 

Time HorizonClearly, the time horizon for each of the client's goals will affect the asset allocation mix. Take the example of a client with a very aggressive risk tolerance. The recommended allocation to stocks will be much higher for the client's retirement portfolio than for the money being set aside for the college fund of the client's 13-year-old child.

Read more: http://www.investopedia.com/exam-guide/finra-series-6/evaluation-customers/risk-reward.asp#ixzz1yhz7GZFU

Risk-Return Tradeoff

Definition of 'Risk-Return Tradeoff'

The principle that potential return rises with an increase in risk. 

• Low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential returns. 
• According to the risk-return tradeoff, invested money can render higher profits only if it is subject to the possibility of being lost. 

Investopedia explains 'Risk-Return Tradeoff'

Because of the risk-return tradeoff, you must be aware of your personal risk tolerance when choosing investments for your portfolio. 

• Taking on some risk is the price of achieving returns; therefore, if you want to make money, you can't cut out all risk. 
• The goal instead is to find an appropriate balance - one that generates some profit, but still allows you to sleep at night.

Read more: http://www.investopedia.com/terms/r/riskreturntradeoff.asp#ixzz1yNTT4zyp

Every Choice Comes with Risk

by Michele Cagan, CPA

In the investment world, you'll have to walk a delicate (and very personal) balance between risk and reward. The more uncertain the investment, the greater the risk that your investment won't perform as expected, or even that you'll lose your entire investment. Along with greater investment risk, though, comes an opportunity to earn greater investment returns. If you're uncomfortable with too much risk and seek to minimize it, your trade-off will be lower investment returns (which can be a form of risk in itself). Truthfully, you can't completely eliminate risk. If you don't take any risk at all, you won't be able to earn money through investing.

Investment risk is directly tied to market volatility — the fluctuations in the financial markets that happen constantly over time. The sources of this volatility are many: interest-rate changes, inflation, political consequences, and economic trends can all create combustible market conditions with the power to change a portfolio's performance results in a hurry. Ironically, this volatility, by its very nature, creates the opportunities for economic benefit in our own portfolios, and that is how risk impacts your investments and your investment strategy.

There are many different types of risk, and some are more complicated than others. The 7 risk classifications you'll learn about here are those you'll likely take into consideration as you begin to design your portfolio.

Stock Specific Risk

Any single stock carries a specific amount of risk for the investor. You can minimize this risk by making sure your portfolio is diversified. An investor dabbling in one or two stocks can see his investment wiped out; although it is still possible, the chances of that happening in a well-diversified portfolio are much more slender. (One example would be the event of an overall bear market, as was seen in the early 1990s.) By adding a component of trend analysis to your decision-making process and by keeping an eye on the big picture (global economics and politics, for example), you are better equipped to prevent the kinds of devastating losses that come with an unexpected sharp turn in the markets.

Risk of Passivity and Inflation Rate Risk

People who don't trust the financial markets and who feel more comfortable sticking their money in a bank savings account could end up with less than they expect; that's the heart of passivity risk, losing out on substantial earnings because you did nothing with your money. Since the interest rates on savings accounts cannot keep up with the rate of inflation, they decrease the purchasing power of your investment over time — even if they meet your core investing principle of avoiding risk. For this somewhat paradoxical reason, savings accounts may not always be your safest choice. You may want to consider investments with at least slightly higher returns (like inflation-indexed U.S. Treasury bonds) to help you combat inflation without giving up your sense of security.

A close relative of passivity risk, inflation risk is based upon the expectation of lower purchasing power of each dollar down the road. Typically, stocks are the best investment when you're interested in outpacing inflation, and money-market funds are the least effective in combating inflation.

Market Risk

Market risk is pretty much what it sounds like. Every time you invest money in the financial markets, even via a conservative money-market mutual fund, you're subjecting your money to the risk that the markets will decline or even crash. With market risk, uncertainty due to changes in the overall stock market is caused by global, political, social, or economic events and even by the mood of the investing public. Perhaps the biggest investment risk of all, though, is not subjecting your money to market risk. If you don't put your money to work in the stock market, you won't be able to benefit from the stock market's growth over the years.

Credit Risk

Usually associated with bond investments, credit risk is the possibility that a company, agency, or municipality might not be able to make interest or principal payments on its notes or bonds. The greatest risk of default usually lies with corporate debt: Companies go out of business all the time. On the flip side, there's virtually no credit risk associated with U.S. Treasury-related securities, because they're backed by the full faith and credit of the U.S. government. To measure the financial health of bonds, credit rating agencies like Moody's and Standard & Poor's assign them investment grades. Bonds with an A rating are considered solid, while C-rated bonds are considered unstable.

Currency Risk

Although most commonly considered in international or emerging-market investing, currency risk can occur in any market at any time. This risk comes about due to currency fluctuations affecting the value of foreign investments or profits, or the holdings of U.S. companies with interests overseas. Currency risk necessarily increases in times of geopolitical instability, like those caused by the global threat of terrorism or war.

Interest Rate Risk

When bond interest rates rise, the price of the bonds falls (and vice versa). Fluctuating interest rates have a significant impact on stocks and bonds. Typically, the longer the maturity of the bond, the larger the impact of interest rate risk. But long-term bonds normally pay out higher yields to compensate for the greater risk.

Economic Risk

When the economy slows, corporate profits — and thus stocks — could be hurt. For example, political instability in the Middle East makes investing there a dicey deal at best. This is true even though much of the region is flush with oil, arguably the commodity in greatest demand all over the planet.

http://www.netplaces.com/investing/designing-your-personal-portfolio/every-choice-comes-with-risk.htm

What is Risk?

Risk  is incorporated  into  so many  different disciplines from insurance to
engineering  to  portfolio  theory  that it should  come as no surprise that it is defined  in
different ways by each one. It is worth looking at some of the distinctions:

a. Risk versus Probability: While some definitions of risk focus only on the probability
of an  event occurring, more comprehensive definitions incorporate both  the
probability  of the event occurring and  the consequences of the event. Thus, the
probability  of a severe earthquake may  be very small but the consequences are so
catastrophic that it would be categorized as a high-risk event.

b. Risk versus Threat: In some disciplines, a contrast is drawn between risk and a threat.
A threat is a low probability  event with very  large negative consequences, where
analysts may be unable to assess the probability. A risk, on the other hand, is defined
to  be a higher probability  event, where there is enough  information  to  make
assessments of both the probability and the consequences.

c. All outcomes versus Negative outcomes: Some definitions of risk tend to focus only
on  the downside scenarios, whereas others are more expansive and  consider all
variability as risk. The engineering definition of risk is defined as the product of the                                               

probability of an event occurring, that is viewed as undesirable, and an assessment of
the expected harm from the event occurring.

Risk = Probability of an accident * Consequence in lost money/deaths

In contrast, risk in finance is defined in terms of variability of actual returns on an
investment around  an  expected return, even  when  those returns represent positive
outcomes.



Risk and Reward
The “no free lunch” mantra has a logical extension. Those who desire large
rewards have to be willing to expose themselves to considerable risk. The link between
risk and return is most visible when making investment choices; stocks are riskier than 
bonds, but generate higher returns over long  periods. It is less visible but just as
important when making career choices; a job in sales and trading at an investment bank

may be more lucrative than a corporate finance job at a corporation but it does come with
a greater likelihood that you will be laid off if you don’t produce results.

Not surprisingly, therefore, the decisions on how much risk to take and what type
of risks to take are critical to the success of a business. A business that decides to protect
itself against all risk is unlikely to generate much upside for its owners, but a business
that exposes itself to the wrong types of risk may be even worse off, though, since it is
more likely to be damaged than helped by the risk exposure. In short, the essence of good
management is making the right choices when it comes to dealing with different risks.






http://people.stern.nyu.edu/adamodar/pdfiles/valrisk/ch1.pdf

A stock price must past 2 tests to be considered reasonable.

The most important task in buying a stock is to determine that the company is a good company, in which to own stock for the long term. 

However, no matter how good the company, if the price of its stock is too high, it's not going to be a good investment.

A stock price must pass two tests to be considered reasonable:

1.  The hypothetical total return

The hypothetical total return from the investment must be adequate - enough to contribute to a portfolio average of around 15 percent - sufficient to double its value every 5 years.

2.  The potential risk 

The potential gain should be at least 3 times the potential loss.




























To complete these tests, you have to learn how to do the following:

• Estimate future sales and earnings growth
• Estimate future earnings
• Analyse past PEs (check the present PE relative to its usual average PE)
• Estimate future PEs.
• Forecast the potential high and low prices
• Calculate the potential return.
• Calculate the potential risk.
• Calculate a fair price.