Risk vs Reward: The Parable of a Squirrel
I was on Youtube a few days ago passing the time as one is oft to do and I came across some interesting videos. Naturally, it first started off watching animals do silly things – like an Orangutan enjoying magic tricks – and then slowly began to devolve the further and further I went through related links. During my travels though I found this amazing little one-minute video about a squirrel venturing for a peanut and all I could think while watching it was “wow, this guy understands risk vs. reward”. The REAL morale of the story though is that I can officially label watching animal videos for two hours as research.
So back to the squirrel video, here it is for your viewing pleasure. It starts with someone’s hand in the foreground holding a peanut near a fence and a squirrel further down the fence cautiously studying the peanut. He then starts to creep forward, backtracking and jumping back at any sign of danger, until he finally reaches the peanut and takes it. You get a great shot of him gingerly taking the peanut in his mouth before he runs like mad in the other direction with his spoils.
The Parable of the Squirrel
Watching this video, you and I know that the person filming just wanted an excellent video to gloat about; however, the danger to the squirrel was very real. “Will he eat me? Capture me?”. Perception was very different to the squirrel. So why risk it? He could also have a very tasty and fattening peanut. Risk vs Reward. We can use this principle of calculated risk to help us achieve wealth through investing
A Risk/Reward ratio is just the reward you expect to gain divided by the amount you could possibly lose. You believe Stock A could go up to $35 from $25; however, it could just as easily stoop down to $20. If you buy, you’ll buy 100 shares. Your potential upside is $10 per share, or $1000; potential losses could be $5 a share, or $500 total. So your risk ratio would be 2:1 ($1000/$500). This quick calculation is an objective metric that an investor cause use to validate a particular investment decision. Do note, this metric is not a be all, end all. It is to be used in conjunction with other factors in deciding to invest. Personally, I won’t look at an investment unless I’m faced with a 3:1 or higher.
Got the hang of the risk/reward ratio? I’m about to kick it up a notch, by adding a little flair to that principle. While risk vs reward is a useful off-the-cuff tool, it doesn’t really give us a clear picture about your risk profile. To do that, we would need to use a probability weighted risk/reward equation. So let’s say I’ve done all this research about a particular stock: I’ve evaluated the company’s ability to make money, looked at their historical prices, and I even like the look of their growth rates. I even think the company is oversold. To throw some numbers in this let’s say I want to buy 100 shares. The stock’s historical low is around $35 per share and currently trading at $37; I think it could drop as low as $33 though. It could also go as high as $50 based on future earnings and where the stock normally trades. my regular risk/reward would be (1300/400) 3.25:1. Adding the probability analysis to the mix, let’s say that I believe the company will hit my $50 target if they make their previous quarter’s earnings expectations because that will bolster investor confidence and stop the bleeding on the price drop. It’s a pretty steady company so I predict a 70% chance to hit their targets. Conversely, should they not hit the earnings, and this will most assuredly cause a drop do $33. My new risk equation would be (1300*.7)/(400*.3) giving a 7.58:1 risk/reward ratio. This is a better analysis because it factors in the projected probability for any given investment. Knowing my own risk profiles, I can better assess if this particular trade is suitable for me. If I change the probability to a 40% chance of success, my risk/reward goes to 2.166:1 and that falls below my threshold because I know my expected earnings isn’t worth the risk I would have to take. Pretty simple right?
Expected Value Real Talk
Realistically, most of you aren’t trading your own individual equities and that’s okay. Your retirement portfolio probably consists of some equity indices and some bonds, so you’re probably thinking this whole risk/reward thing doesn’t really apply to you – and you would be wrong.
Retirement planning is simply a goal-setting phase to achieve some number you think is suitable to leave the work force on. Just because someone else is trading your individual stocks, doesn’t mean you shouldn’t be focused on a risk-based approach to investing. You need to be having a realistic discussion about what the chances are of hitting your retirement goals, but also within the time frame you deem appropriate. And you should always be forward thinking. If you think the economy is slowing down and the markets are about to crash, moving to cash and bonds is probably a smart idea; if the market is heating up and about to hit a big run then you want to be over-extended in stocks to take advantage of it. That’s why I recommend reallocating twice a year and rebalancing once a quarter in your individual retirement accounts. When it comes to building the biggest retirement, it’s amazing what nature can teach us. If you want the biggest retirement nut, you should follow the example of the squirrel – using probability analysis in a risk vs reward scenario.