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 donít 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 doesnít 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 itís the great depression and things are different today. Donít 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. Letís 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:
Donít risk more than 2% on any given trade or idea. That doesnít 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
Donít 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.
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.