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Risk and RewardIf 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 don't 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 doesn't 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 it's the great depression and things are different today. Don't 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. Let's 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: Don't risk more than 2% on any given trade or idea. That doesn't 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 Don't 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 time. 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 losses. I hope that risk and reward become the primary strategy concern in your future investing and trading. Other articles by this author »
About John McKeon
John McKeon- pivate placement fund manager and owner of buypanic.com, an investment newsletter. I also have over 25 years experience in trading with a specialization in stock index trend following. Related
And here is another random article you might be interested in... A Career with the FBIDo you have what it takes to become an FBI special agent? Do you have a sincere desire to enforce federal laws and investigate crimes? This job requires hard work and can often times be dangerous and stressful. You'll undoubtedly be in close contact with crimminals and victims of crime. But a special agent's job is rewarding if you enjoy serving the public. Long before applying for a job as an FBI special agent, you'll need to plan carefully what you need to do to qualify. The FBI Special Agent Federal Bureau of Investigation (FBI) special agents are the Government's primary investigators, who investigate criminal violations of over 260 statutes not assigned to another federal agency. Agents may conduct surveillance, monitor wiretaps, examine financial records, or participate in undercover assignments, just to name a few. The FBI investigates organized crime, white collar crime, such as health care fraud, counterterrorism, copyright infringement, civil rights violations, bank robbery, extortion, kidnapping, terrorism, espionage, violent crimes, drug trafficking, and other violations of Federal statutes. The following was adapted from The Federal Bureau of Investigation, Facts and Figures 2003, FBI Priorities (http://www.fbi.gov/priorities/priorities.htm) The FBI's priorities are to:
Entry Requirements
The FBI looks for job applicants who have skills in interrogation, report writing, surveillance, and giving testimony. The selection process also includes cognitive tests, an interview, background check, polygraph test, and drug test. The FBI also looks for individuals with character traits, such as honesty and sound judgement. Physical Training Requirements An example of a requirement would be the PRT, a 1.5 mile run test, passed with scores of 14 minutes 10 seconds or under for females and 12 minutes 40 seconds or under for males. Forensic Science The candidate for a scientist position must first qualify under an existing entry program and have a degree in physics, chemistry, mathematics, biology, nursing, bio-chemistry, Forensics, Medical specialties, or related field. The candidate for a Forensic Scientist position should major in biochemistry, biology or biotechnology. The Forensic scientist analyzes evidence such as hairs, firearms, DNA, photographs, fingerprints, and handwriting examples and testifies verbally and in writing. Advice from a former FBI profiler John Douglas, a former FBI profiler, offers the follow advice for aspiring FBI special agents:
Don't major in a course you dislike, such as accounting, because you think it will help you to become a special agent. "Make sure your primary focus is finding a career you enjoy," says Douglas. For more information on employment as a FBI Special Agent, check your phone directory for your state FBI office. Or visit the FBI online. Sources the Occupational Outlook Handbook 2002-2003, US Department of Labor, Bureau of Labor Statistics Federal Bureau of Investigation (www.fbi.gov) John Douglas's Guide to Careers in the FBI,1998, Kaplan Books, Simon and Schuster, New York. Other articles by this author »
About Diana Clarke
Diana Clarke has taught job search skills to students in Silicon
Valley. Her career and business articles have appeared in
publications including the San Jose Mercury News, Cupertino Courier
and the Saratoga News. Related
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