Risk and Reward

If you are doing your ain investing in the stock market, what would be the first inquiry you would inquire yourself before you do any trade or investment? If your reply 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 have gone down 50% inch the last 6 months, or whether the volatility is low now so it is a good clip to purchase or sell, then you are probably on the route to ruin. These strategies have got got nil in common with each other and there are all sorts of different criteria that I did not advert that have nil in common with each other. However no matter what type of strategy you utilize to do your investing decisions, there is only one important inquiry that must be asked before you draw the trigger and do the trade. That is, what is my hazard and what is my reward on this trade. Even if you are going to purchase a stock and throw it for a long time, you still have got to be aware of your hazard and your reward. Why? Because the full stock market may be here for the remainder of your life, any 1 stock might not be. You think, that is all right Iodine diversified a batch so I don’t need to cognize hazard and reward. Wrong.

Diversification is great, but you should still be aware of the hazard and reward because even indexes of the full market have got a hazard and a reward, depending on the length of clip invested. Point of entrance, exit, stops, and diversification, are all of import things, but they by themselves are not hazard and reward. You have got to inquire yourself how much am I risking, and what my possible reward is. How much are the of import words

Okay how make I make that? Well first you must define your investing strategy. If you desire to purchase and throw what exactly makes that mean. Hold for 5 years, 10 years, or forever? What is forever? If you are 20 old age old forever is different than if you are 55. Also if you are purchase and holding, is forever when you halt investment or is it when you begin withdrawing money? These are of import inquiries that must be answered specifically. You might state it doesn’t matter because I will be diversified with index finances for the adjacent 15 years. Okay allow me inquire these questions. Are you 100% invested at all times? Bash you cognize the upper limit drawdown (the largest loss from the index high and low in any 15 twelvemonth period) for the index you invested in? Are you able to financially defy that sort of drawdown? Alright, Iodine cognize these are a batch of inquiries and all you desire to make is put in an index common monetary fund for the adjacent 15 old age and forget about it.

Well I am going to state right now that if you believe you are taking very small hazard on 15 old age you are wrong. If you bought the S&P Five Hundred in a 100% place in 1965 and needed the money in 1980 you would have got made no tax return on investing and had a 40% drawdown from 1969 to 1975. If you look at the time time period of 1930 to 1955, a 25 twelvemonth period it is even worse. I cognize it’s the great depression and things are different today. Don’t presume anything. I am not saying that you should not invest. I am just saying that there is a hazard and a reward. Every clip you merchandise whether it is once a hebdomad or once every 15 years, that trade have a opportunity of winning and a opportunity of losing. Also, when you purchase a managed common monetary fund for 15 old age you are not buying and holding. You are buying and merchandising but you are paying a professional to make it for you. He or she will have got draw down feathers in the monetary fund and hopefully he or she will be looking at hazard and reward for you. Even an index monetary fund held for 15 old age is not truly purchase and throw because the indexes change on a annual basis. Some pillory come up in the index and some pillory travel out of the index. The longer the clip span, state 40-55 years, the bigger the hazard but the bigger the reward. Also the longer the clip span, the longer you can defy a large drawdown if it comes.

Now what if you are trading pillory with an entry and an issue point already predefined; that is where make I get in and where make I get out. That strategy might be good but that is not hazard and reward. The most of import inquiry is how much am I invested and how much make I get out. What is the % of hazard on each stock place in the portfolio and what is the hazard to the sum portfolio. Let’s take an example. You bought 100 shares IBM @50 for $5000 in a sum portfolio of $200.000. You set a sell halt loss to sell all 100 shares if IBM travels to $40 / share. That agency your hazard on IBM is $10 / share or $1000. But your existent hazard to your portfolio is .5% Oregon $1000 divided by $200,000. If you have got a sell issue point of $100 then your reward on the stock would be 100% and the reward to your sum portfolio was 2.5%. So your sum hazard to reward was 5 to 1. You could crunch numbers all twenty-four hours to do up expressions to suit your strategy, but the most of import portion is how much are you risking. Here are some general regulations when it come ups to risk:

Don’t put on the line more than 2% on any given trade or idea. That doesn’t matter if your strategy is technical or cardinal or discretionary. Risking 1% would be safer. Most large monetary fund managers hazard much less.

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

Don’t hazard more than 20% of your portfolio at any 1 time, 10% would be better. You have got got to have a manner to quantify the greed factor or it might devour you and all your money at the same time.

In my ain portfolios I seek not to put on the line more than than 7% on an initial portfolio position.

Initial hazard and on going hazard can be two different risks. As a trade goes profitable the amount of at hazard at any minute in clip can be a variable not a constant. That would allow for letting net income run while cutting losings short. However, making your initial hazard a variable in most cases would be a disaster. Once initial hazard is conceived it should never be increased. Greed may go the primary factor in increasing initial hazard and that is always a fast path to increasing losses.

I trust that hazard and reward go the primary strategy concern in your hereafter investment and trading.