Evaluating risk when buying stocks

Some of my recent posts here about methods for stock investing have gotten a lot of attention, and I’m glad. But have you ever wondered how to evaluate whether or not a stock is really worth your time and money? How can you set limits in case a stock drops in value and how can you recognize a good deal?

Here’s some great info about setting limits and determining risks for investing in stocks, from investopedia.com:

Now let’s look at this in terms of the stock market. Assume that you did your research and found a stock you like. You notice that XYZ stock is trading at $25, down from a recent high of $29. You believe that if you buy now, in the not-so-distant future, XYZ will go back up to $29 and you can cash in. You have $500 to put towards this investment, so you buy 20 shares. You did all of your research but do you know your risk/reward ratio? If you’re like most individual investors, you probably don’t.

Before we learn if our XYZ trade is a good idea from a risk perspective, what else should we know about this risk/reward ratio? First, although a little bit of gut feeling finds its way in to most investment decisions, risk/reward is completely an objective. It’s a calculation, and the numbers don’t lie. Second, each individual has their own tolerance for risk. You may love bungee jumping, but somebody else might have a panic attack just thinking about it.

Next, risk/reward gives you no indication of probability. What if you took your $500 and played the lottery? Risking $500 to gain millions is a much better investment than investing in the stock market, from a risk/reward perspective, but a much worse choice in terms of probability.

The Calculation
The calculation of risk/reward is very easy. You simply divide your net profit (the reward) by the price of your maximum risk. Using the XYZ example above, if your stock went up to $29 per share, you would make $4 for each of your 20 shares for a total of $80. You paid $500 for it, so you would divide 80 by 500 which gives you 0.16. That means that your risk/reward, for this idea, is 0.16:1. Most professional investors won’t give the idea a second look at such a low risk/reward ratio, so this is a terrible idea. Or is it?

Let’s Get Real
Unless you’re an inexperienced stock investor, you would never let that $500 go all the way to zero. So, your actual risk isn’t the entire $500. Every good investor has a stop-loss, or a price on the downside that limits their risk. If you set a $29 sell limit price as the upside, maybe you set $20 as the maximum downside. Once your stop-loss order reaches $20, you sell it and look for the next opportunity. Because we limited our downside, we can now change our numbers a bit. Your new profit stays the same at $80, but your risk is now only $100 ($5 maximum loss multiplied by the 20 shares that you own) 80/100= 0.8:1. This is still not ideal.

What if we raised our stop-loss price to $23, risking only $2 per share or $40 loss in total? 80/40 is 2:1, which is acceptable. Some investors won’t commit their money to any investment that isn’t at least 4:1, but 2:1 is considered the minimum by most. Of course, you have to decide for yourself what the acceptable ratio is for you.

Notice that to achieve the risk/reward profile of 2:1, we didn’t change the top number. When you did your research and concluded that the maximum upside was $29, that was based on technical analysis and fundamental research. If we were to change the top number, in order to achieve an acceptable risk/reward, we’re now relying on hope instead of good research. Every good investor knows that relying on hope is a losing proposition. Being more conservative with your risk is always better than being more aggressive with your reward. Risk/reward is always calculated realistically, yet conservatively.

You can read the whole post here: http://www.investopedia.com/articles/stocks/11/calculating-risk-reward.asp

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