Investing Tools for Investors Looking to Excel
10/21/02  

Risk Threshold

Risk threshold is how much risk you can bear (financially and emotionally) to achieve a target rate of return. The greater the rate of return you seek, the likelier you will encounter some major bumps along the road. If you can't take air pockets, don't fly, and if you can't take losses, buy t-bills (risk free short term government debt obligations). Hazarding a loss of some magnitude to have an opportunity to gain is what risk is about.

Risks have the explicit cost of the loss, but they can involve an opportunity cost, which is what the money might earn if more or less risk was incurred. If you opt to buy T-bills at 4.7% and a stock you could have bought goes up 50%, you know about opportunity cost.

High rates of return involve investing in small emerging companies which can be moon shots or disasters. You can wake up one morning and hear the company missed their numbers or that their accounting treatment is causing a restatement of past earnings, or the company lost a contract, or that clinical trials proved the drug was ineffective, etc. These types of small companies that may be "pure plays" in something or other, can either explode up or implode if the trend persists or dies. Losing 25% to 50% of their value happens to small companies in a day. On the other, if you find the next Microsoft, you can cover these losses and still allow for a great result.

Another negative outcome can be stocks that simply reached values that could not be supported by future earnings. Often, momentum investors keep buying stocks ad infinitum and ultimately ad nauseum. Look what has happened to the "hyped" restaurant and bio-tec stocks. What's become of Planet Hollywood or Rainforest, of Chucky Cheese. But overvaluation from a fundamental perspective and overbought from a technical perspective can last for long periods of time. If the company or industry fails, if the premise cracks, then the higher the overvaluation, the longer the time spent overbought, the more vertical the price move, the riskier the return trip. "Roundtrippers" in a stock is your most expensive ride particularly from an emotional perspective. A roundtripper is where you enter a stock at an optimal point, you watch the stock double, and then, do to overvaluation or a failed investment premise (business problem), the stock goes down to your investment entry point or lower. 

Quants (those who do quantitative analysis and have math degrees) refer to risk in terms of standard deviation. This is how much a portfolio rises above or below a mean performance expectation. When you feel sick at your stomach, you'll know real risk .

Experienced investors normally will calculate the risks to their investments. What can go wrong and what the impact might be to earnings and stock value. There are market risks and business risks. Both should be considered. The premise to an investment should be revisited to see if it is valid. If not, sell. In effect, if you don't sell a stock, you are buying it.

Experienced investors don't fall in love with their investments. If the the logic breaks or the stock technically breaks down, you sell and ask questions later. Technicians know a broken chart has logic. They don't wait to find the reason why.

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