Many decisions in life are based on risk versus reward. That’s certainly true for investing, or at least I think it should be true. How much can you gain and how much can you lose. Then you can layer on your assessment of the probabilities of the outcomes. Sure, you can be wrong in your assessments of both the upside and the downside as well as the probabilities of each possible outcome. But before we get into assessments of the upside/downside magnitude and their associated probabilities, let’s start with the basic idea about different people’s views of risk and reward. I think that the best investors are able to simultaneously see both risks and rewards. The rest tend to lean toward seeing the risks more or seeing the rewards more. At the extremes are people who see only risks or only rewards.
THE EAGER BEAVER
The first extreme group tends to get very excited about a new investment idea. They may have just heard about it from a friend or on the news, or they may know somebody who just made a lot of money on that investment. The eager beaver looks exclusively at how much he could make and doesn’t consider the downside. His decision making relies on “intuition”, which could often also be defined as hope, rather than on numbers, facts, and analysis. When he over allocates, the eager beaver can really hurt his returns, and, when he over allocates to an extreme and repeatedly, the results can be disastrous.
THE NERVOUS NELLIE
The other extreme group tends to be very fearful of losing money. They look mainly at the risks and all the potential problems and pitfalls. Rather than taking a calculated risk, the nervous nellie play it safe in low yielding investments. While she may not lose money investing, she typically underperforms.
BALANCE IS THE KEY TO HIGHER RETURNS
Investors who simultaneously recognize the upside and the downside are at a great starting point to achieving superior investment returns. Not only does this mindset take out much of the emotion from the investment decision, it also forces the investor to dig deeper into both the risks and the rewards. For instance, are the risks really that likely and what is the actual magnitude should that risk come to pass. The same thought process is applied to the rewards. Taking a critical look at all factors, both positive and negative, is an important aspect of analyzing an investment opportunity. Finally, the investor retains flexibility as to whether the investment should be made until the analysis is complete.
DOING THE HOMEWORK
Yet, the right mindset is only the beginning. Investors still need to put in the effort to assess whether an investment is worthy of hard-earned dollars. There are really no shortcuts. Perhaps many investors don’t know where to even begin to assess/analyze an investment opportunity. This is a common dilemma: “I want to invest, but I don’t know how to analyze a company to arrive at an opinion.” In fact, even successful investors where at one point lost with respect to where to start. I am writing a series of posts on Growth Stock Analysis (currently there are seven parts to this series). The posts can be found in the Growth Stocks section of the blog.
PULLING THE TRIGGER
After someone’s done the homework and has decided to invest in a particular company’s stock, the next question becomes how much to invest. This is something that each investor must decide for himself/herself. Portfolio construction and individual investment allocation are topics for a future blog post. For me, allocation is a function of my assessment of risk/reward in combination with conviction. But remember that eager beavers often have more conviction than is warranted while nervous nellies have little or no conviction at all. When it comes to the question of allocation, perhaps the eager beavers would be well served to spread out their dollars into more than just one investment. Similarly, the nervous nellies will likely do better if they put at least something into investments that can achieve high(er) returns.
The opinions, thoughts, analyses, stock selections, portfolio allocations, and other content is freely shared by GauchoRico. This information should not be taken as recommendations or advice. GauchoRico does not make recommendations and does not offer financial advice. Each person/investor is responsible for making and owning their own decisions, financial and otherwise.