Risk Versus Reward

The Role of Risk with Stock Investments

Risk with buying and selling stocks equates to the potential for losses within a given strategy. It is the potential for differences between what you bought it for and what you sold it for, or vice versa with short positions.

The maximum amount of risk in a stock play is the amount of your investment if you are on the long side, although there is no theoretical limit as far as the risk of short plays. As the stock rises, you lose money, and there is no cap on how much a stock can rise in theory. However, in practice, a short position will be closed on you when you can no longer maintain the minimum account balance needed, which does serve as a cap.

Buying and selling stocks is less risky than many other types of investments. Stocks are riskier than bonds, but tend to be less risky than most other types of securities plays. With options for instance, your investment may expire worthless, and with binary options if your bet isn’t correct you lose the whole thing as well.

Other types of investments, like forex and derivatives, have the potential to be much more highly leveraged. Stocks can generally only be leveraged 2:1, but forex and derivatives can be leveraged 400:1 or even more. This additional leverage allows the trader to choose more risk, as desired, in the interests of increasing one’s profit potential.

Risk is therefore not a bad thing in itself and is actually a part of what makes investing in stocks and other financial instruments viable, which is volatility. If not for volatility, the price of something would not change or just trade in a very tight range. This is much like the person who gets some money and buries it in the back yard, they don’t lose money, at least nominally, although they do lose to inflation.

Someone else invests the money, and while there is risk involved, they put themselves in a position to make a profit. If the money is placed wisely, this provides a good opportunity for this to happen, although of course if it is not placed wisely, one may become worse off than the person who buries their money and whose goal is to just preserve the nominal value of the money.

Risk and Reward Tend to Go Together

How much risk one is going to want to take on with stock plays or with any type of financial investment will depend on one’s risk appetite. While this plays a big role, as one does not want to exceed one’s risk appetite generally, the other side of this is what sort of return one is seeking.

Risk Versus RewardBoth of these factors need to be accounted for in order to seek the right balance between risk and reward. If someone was faced, for instance, with the need to achieve a certain return to accomplish an important financial objective, with a lesser return not being acceptable, one may need to take on more risk than they normally would be comfortable with.

Investment advisors are required to evaluate both of these elements prior to making recommendations, and investors often do not understand that these cannot be treated separately. They are strongly related, and the objective side isn’t just a matter of having people claim that they want to make as much money as possible, it’s more what they require, and certain people will require certain types of returns over time.

On the other hand, a lack of risk appetite may preclude their taking on certain risks, and we need to look at what will happen if the investment does not succeed to gain insight on this. If one is investing extra money that they could decline in value without any real hardship, this will be different than one’s life savings which will be needed for retirement soon.

There are a variety of different strategies that can be pursued depending on one’s preferences here for risk and return. The first one is deciding what percentage of stocks one’s portfolio should consist of, one’s growth component, from the entire portfolio to none. Of the three major asset classes, stocks present the highest risk and reward. The safest class is savings, with the lowest risk and return, with the income class, such as bonds, falling in the middle in terms of both risk and potential return.

Within the class of growth investments, certain types of stocks are going to be risker and have more reward than others, and some are going to be less risky. This is all about degrees of volatility, and certain types of stocks have more volatility than others.

Volatility determines how much risk and return there is in an investment, and something that can go up more can generally go down more as well because its price moves more. Bonds are less volatile than stocks generally, and savings is the least volatile, and may have no volatility at all, for instance with a certificate of deposit that guarantees a certain return over a certain period.

There is even risk with certificates of deposit though, the bank where it is held may go under, and there’s also inflation risk, which determines the real value of the investment at maturity. The nominal value isn’t volatile though, and this is what we normally speak of when we reference volatility, the nominal value of the asset changing over time.

Managing Risk with Stocks

Ideally, we want to prefer a strategy that looks to take advantage of the upside of volatility while minimizing the downside risk. While risk and reward do tend to go together, they can be managed in such a way that the risk involved can be reduced relative to reward.

A good example of this would be the strategy of holding stocks over a long period of time. The idea here is that due to the way that money in the stock market tends to increase over long periods of time, the risk that one may sell at a loss or even not gain a good return is reduced.

In this case you are more likely to get the better return over time that stocks tend to deliver and are expected to continue to deliver, without the usual risk involved in achieving these investment objectives. There still is risk involved, for instance people may move away from stocks during that time, or the economy may be mired in a long recession, but overall this strategy does tend to manage the overall risk well.

On the other side of the spectrum, many traders manage their risk by simply looking to limit their losses with trades to very small amounts, where they simply exit the trade if it moves against them by a certain amount.

These traders may consider holding a position overnight as being way too risky for them, as when it opens up again, it may do so with a price movement against them that could be what they consider very excessive, and well beyond what they would normally tolerate in a trade.

There still may be a lot of risk involved in such a trading strategy. It is not the amount that one is exposed to in a given trade, which is kept small, it is the systemic risk of not having the right strategy and seeing these small losses pile up too much relative to the gains the strategy provides.

If enough skill is employed though, such a strategy may achieve the goal of seeking higher returns with even less risk than typical investing. If the system used is a good one, this can outperform the market dramatically while minimizing the risk of investing, which is the ultimate goal in stock trading.

Online trading takes this to an even higher level, as they enter and exit positions in fractions of a second. This does expose them to the least risk possible in a trade, although the computer program that is looking to take advantage of these very small opportunities to achieve very small gains needs to be sound for the plan to work.

These programs are run by big institutions though and they do know what they are doing. While this is beyond the scope and ability of individual traders, it does demonstrate that one need not hold stocks for a minimal amount of time to make money in the stock market, and computerized trading generates a great deal of profit indeed.

To sum all this up, one must first choose how much volatility one wants to expose themselves to, and then come up with strategies that look to take advantage of the potential returns of these investments while looking to manage the risk side of things strategically.

In between the buy and hold strategy and the very quick trades that some traders use, there are a multitude of different options that can be chosen, although all of them need to be well designed to actually increase reward and reduce risk.

Seeing a stock go up and down a lot is seen by some as not a desirable characteristic, but others may see significant opportunity here and may seek to take positions that will take advantage of this volatility.

The more predictable these movements are, the easier they are to take advantage of. Stock prices do not go up and down in an orderly fashion though, the price movements tend to be pretty jagged actually, but overall, in a way that can be understood if the right technique is used.

We need both a good plan and the resolve to execute it properly, and the risk of not doing so must also be accounted for. In the heat of battle, this can lead to bad decisions with all forms of trading and investing, and this might even be the most important element of success in buying and selling stocks, making sure that you execute whatever plan you have properly.

Managing risk and reward is the most important element in the success of stock plays, and while people can still make money in the stock market without this being done effectively, in order to get the most out of all this, risk and reward elements bear paying attention to.

John Miller

Editor, MarketReview.com

John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.

Contact John: john@marketreview.com

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