What Makes An Investment A Good Investment?
In a nutshell, the lower the risk and the higher the expected return, the better the investment!
But we run into a problem whenever we try to define both the risk and the expected return, and then try to compare whatever we've come up with to other investment choices.
Yes it's difficult, but not impossible, to make an apples-to-apples comparison by simply coming up with a ratio of reward versus risk. And to get this ratio, we need to look at the performance of various indexes over a consistent period of time, and then adjust their returns for risk-free interest. (In other words, deduct the current T-Bill rate from the returns of other investments in order to express their returns in terms of risk-free interest.)
A good rule to follow is to always have a reward-to-risk ratio of at least three-to-one. Which means that if you can't make three times whatever you have at risk in a stock, then that stock just isn't worth it.
This is easy to figure out whenever you use trailing stops to protect yourself. For example, if you buy a stock priced at $100 per share using a 20% trailing stop, that means you would sell it at $80 in order to limit your risk. And further, it also means that if you are willing to risk 20% of your money on that stock, then you had better be looking for a return of 60% or more, or that stock is not worth buying!
When you take the time to compare the risk-reward ratios of different investments, you give yourself a much clearer understanding of what to expect for your money.
Thus, if you know your risk, and your potential return is favorable to you in relation to the risk you are willing to take, then you have made a good investment!
* * * * *
But we run into a problem whenever we try to define both the risk and the expected return, and then try to compare whatever we've come up with to other investment choices.
Yes it's difficult, but not impossible, to make an apples-to-apples comparison by simply coming up with a ratio of reward versus risk. And to get this ratio, we need to look at the performance of various indexes over a consistent period of time, and then adjust their returns for risk-free interest. (In other words, deduct the current T-Bill rate from the returns of other investments in order to express their returns in terms of risk-free interest.)
A good rule to follow is to always have a reward-to-risk ratio of at least three-to-one. Which means that if you can't make three times whatever you have at risk in a stock, then that stock just isn't worth it.
This is easy to figure out whenever you use trailing stops to protect yourself. For example, if you buy a stock priced at $100 per share using a 20% trailing stop, that means you would sell it at $80 in order to limit your risk. And further, it also means that if you are willing to risk 20% of your money on that stock, then you had better be looking for a return of 60% or more, or that stock is not worth buying!
When you take the time to compare the risk-reward ratios of different investments, you give yourself a much clearer understanding of what to expect for your money.
Thus, if you know your risk, and your potential return is favorable to you in relation to the risk you are willing to take, then you have made a good investment!
* * * * *
posted by Bob Moser at
8:23 PM
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