Risk and Reward by cmlang


									by: John McKeon

If you are doing your own investing in the stock market, what would be the first question you
would ask yourself before you make any trade or investment? If your answer is how
fundamentally sound the stock is, or whether the stock just broke out of a trading range on a
chart, or the fact that the stock has gone down 50% in the last 6 months, or whether the volatility
is low now so it is a good time to buy or sell, then you are probably on the road to ruin. These
strategies have nothing in common with each other and there are all kinds of different criteria
that I did not mention that have nothing in common with each other. However no matter what
type of strategy you use to make your investment decisions, there is only one crucial question
that must be asked before you pull the trigger and make the trade. That is, what is my risk and
what is my reward on this trade. Even if you are going to buy a stock and hold it for a long time,
you still have to be aware of your risk and your reward. Why? Because the entire stock market
may be here for the rest of your life, any one stock might not be. You think, that is okay I
diversified a lot so I dont need to know risk and reward. Wrong. Diversification is great, but you
should still be aware of the risk and reward because even indexes of the entire market have a risk
and a reward, depending on the length of time invested. Point of entrance, exit, stops, and
diversification, are all important things, but they by themselves are not risk and reward. You
have to ask yourself how much am I risking, and what my potential reward is. How much are the
important words

Okay how do I do that? Well first you must define your investment strategy. If you want to buy
and hold what exactly does that mean. Hold for 5 years, 10 years, or forever? What is forever? If
you are 20 years old forever is different than if you are 55. Also if you are buy and holding, is
forever when you stop investing or is it when you start withdrawing money? These are important
questions that must be answered specifically. You might say it doesnt matter because I will be
diversified with index funds for the next 15 years. Okay let me ask these questions. Are you
100% invested at all times? Do you know the maximum drawdown (the largest loss from the
index high and low in any 15 year period) for the index you invested in? Are you able to
financially withstand that kind of drawdown? Alright, I know these are a lot of questions and all
you want to do is invest in an index mutual fund for the next 15 years and forget about it. Well I
am going to say right now that if you think you are taking very little risk on 15 years you are
wrong. If you bought the S&P 500 in a 100% position in 1965 and needed the money in 1980
you would have made no return on investment and had a 40% drawdown from 1969 to 1975. If
you look at the period of 1930 to 1955, a 25 year period it is even worse. I know its the great
depression and things are different today. Dont assume anything. I am not saying that you should
not invest. I am just saying that there is a risk and a reward. Every time you trade whether it is
once a week or once every 15 years, that trade has a chance of winning and a chance of losing.
Also, when you buy a managed mutual fund for 15 years you are not buying and holding. You
are buying and selling but you are paying a professional to do it for you. He or she will have
draw downs in the fund and hopefully he or she will be looking at risk and reward for you. Even
an index fund held for 15 years is not truly buy and hold because the indexes change on a yearly
basis. Some stocks come in the index and some stocks go out of the index. The longer the time
span, say 40-55 years, the bigger the risk but the bigger the reward. Also the longer the time
span, the longer you can withstand a large drawdown if it comes.
Now what if you are trading stocks with an entry and an exit point already predefined; that is
where do I get in and where do I get out. That strategy might be good but that is not risk and
reward. The most important question is how much am I invested and how much do I get out.
What is the % of risk on each stock position in the portfolio and what is the risk to the total
portfolio. Lets take an example. You bought 100 shares IBM @50 for $5000 in a total portfolio
of $200.000. You put a sell stop loss to sell all 100 shares if IBM goes to $40 / share. That means
your risk on IBM is $10 / share or $1000. But your real risk to your portfolio is .5% or $1000
divided by $200,000. If you have a sell exit point of $100 then your reward on the stock would
be 100% and the reward to your total portfolio was 2.5%. So your total risk to reward was 5 to 1.
You could crunch numbers all day to make up formulas to fit your strategy, but the most
important part is how much are you risking. Here are some general rules when it comes to risk:

Dont risk more than 2% on any given trade or idea. That doesnt matter if your strategy is
technical or fundamental or discretionary. Risking 1% would be safer. Most large fund managers
risk much less.

Diversify. Buying 1% risk on IBM and 1% on Dell and 1% on Hewlard Packard is a 3% risk
because they all sell the same products

Dont risk more than 20% of your portfolio at any one time, 10% would be better. You have to
have a way to quantify the greed factor or it might consume you and all your money at the same

In my own portfolios I try not to risk more than 7% on an initial portfolio position.

Initial risk and on going risk can be two different risks. As a trade becomes profitable the amount
of at risk at any moment in time can be a variable not a constant. That would allow for letting
profits run while cutting losses short. However, making your initial risk a variable in most cases
would be a disaster. Once initial risk is conceived it should never be increased. Greed may
become the primary factor in increasing initial risk and that is always a fast track to increasing

I hope that risk and reward become the primary strategy concern in your future investing and

This article was posted on November 29, 2004

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