Advice: Understanding Risk vs. Reward is a Key to Successful Investing

Any investment carries risk. This is a true statement.

Then again, so does NOT investing, but most of you on here knew that, already. That's why you're reading something like this.

So let's take a look at risk.

When is an investment a "good" risk?

The simple answer is, "When it works!"

There is a better, more practical answer, though.

First, it is important to realize that, if you invest enough, you will almost certainly lose sometimes. If you cannot live with this, you have NO business investing, in my opinion.

Next Biggest Investing Mistaken Belief

Most people think that it is important to have more winning investments than you do losing investments.

This CAN be true, but it is not necessarily true.

It is possible to have more losing investments than winning ones and still be profitable.

Being profitable by having more losing investments than winning ones? How?

Most people lose their focus on the main goal: making money--not winning trades.

A Wrong Assumption of the Important Risk vs. Reward Factor

Most people, if you ask them, truly believe that you have to risk more to gain more.

I agree that you need to take SOME risk, but I don't think that you greater risk guarantees greater chance of making greater returns.

You need to be bold, though!

I've heard some people mention the excellent advice that you should invest where there is more upside than downside. In fact, this realization is a great first step.

What I see from many of these same people, however, is something like the following:

Example #1: XYZ Stock, Today's Price $75/share

Projections: Downside = $74/share, Upside = $77/share

Prognosis: The investor/trader sees that there is a $1 downside and a $2 upside, which is true. However, that person sees a 2:1 upside in his or her investment.

At first, this seems to be great, and I agree that this IS better than a 1:2 upside to downside ratio.

Let's look at this in terms of applied numbers, though, outlining a purchasing scenario.

Investment: 100 shares @ $75/share = $7500 initial investment cost (not including commission)

Worst Case Scenario: $74/share --> $7400 = $100 Loss (1.3% loss)
Best Case Scenario: $77/share --> $7700 = $200 Gain (2.6% gain)

Yup! Your upside really is double your downside, but are you really excited about positioning yourself to lose ANYTHING for a 2.6% gain? I can get something similar to that in a bank CD without risking ANY loss.

To be fair, you can probably do a trade like this several times during the year, drastically improving your annual return just through simple multiplication (OK investment 3-5 times during the year = much higher return).

Again, this 2.6% is the TOP of the potential range, though. Are you really excited with a 1.3% gain? Are you willing to risk a loss for it?

Example #2: ZYX Stock Option Play

Situation: This person bought a call option that will not expire for about a year. (For those of you who do not know what a call option is, do not worry. This explanation will remain non-technical. The point is more important than the details here.)

The person put $2500 into the initial investment. The downside is that he can lose everything. The upside is unlimited, technically. However, a lot of things would need to go right for it to be worth $10,000 when this option expires.

Recap: Initial Investment = $2500; Downside = $0 Ending Value; Upside = $10,000 Ending Value

Prognosis: The investor/trader sees that there is a $2500 downside and a $7500 upside, which is true. That person sees a 3:1 upside in his or her investment.

At first, this seems to be a really good investment. A 300% increase seems really promising.

However, there is one really big problem with this. There is less than a 1 in 10 chance of the maximum upside happening, but there is a better than 1 in 4 chance that he loses everything.

To me, it seems like he is risking everything without having a good enough of avoiding it. He appears to be overlooking the LIKELINESS of an event happening--either event.

Let's look at this in terms of applied numbers, though, outlining multiple purchasing scenarios.

Investment #1: Start = $2500; Finish = $10,000
Investment #2: Start = $2500; Finish = $0
Investment #3: Start = $2500; Finish = $0
Investment #4: Start = $2500; Finish = $0
Investment #5: Start = $2500; Finish = $0
Investment #6: Start = $2500; Finish = $2500
Investment #7: Start = $2500; Finish = $1500
Investment #8: Start = $2500; Finish = $3500
Investment #9: Start = $2500; Finish = $3500
Investment #10: Start = $2500; Finish = $5000

Total: Start = $25,000; Finish = $26,000

This is strictly an estimated scenario, but this represents a statistically likely sequence with investments similar to this. You're essentially breaking even.

Does it seem like a great idea to risk everything for an investment that is statistically likely to draw even? To me, that's a bet--not an investment.

Likeliness of Reward is Key to Assessing Risk vs. Reward

I prefer to find something like the following scenario:

Example #3: ABC Stock, Today's Price $3/share

Projections: Downside = $2.50/share, Upside = $8/share

Prognosis: There is a 10:1 upside, but that is not what I see. I look in terms of (a) potential gain/loss percentages and (b) likeliness of occurrence.

The real downside is 17%, and the real upside is 167%. In this case, the likelihood of this reaching the biggest downside is okay, but there is nearly no chance of it staying there long term. It happens to be in an industry that has been beaten, already. However, industry insiders know that it will rebound in a few years. So, at the worst, the likelihood of the price improve "only" halfway at 83% is more likely to happen than losing 17%.

Is there some risk? Yes, but I think it is intelligently calculated.

The bottom line is that you need to take SOME risk, but you need to consider your reward AND the chances collecting that reward. It's also a good idea to estimate the chances of the worst-case scenario happening.

At first, this seems to be great, and I agree that this IS better than a 1:2 upside to downside ratio.

Let's look at this in terms of applied numbers, though, outlining a purchasing scenario.

Investment: 100 shares @ $75/share = $7500 initial investment cost (not including commission)

Worst Case Scenario: $74/share --> $7400 = $100 Loss (1.3% loss)
Best Case Scenario: $77/share --> $7700 = $200 Gain (2.6% gain)

Yup! Your upside really is double your downside, but are you really excited about positioning yourself to lose ANYTHING for a 2.6% gain? I can get something similar to that in a bank CD without risking ANY loss.