Determining Your Acceptable Level of Risk

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Determining your investment strategy will largely depend on your stomach for risk. Risk is the probability that you will lose the original amount you put into the investment. Notice the qualifier "original amount." As a rule, if you lose all your profits and wind up back with the original amount you invested, for investing purposes you've broken even. Although that scenario would be a pretty pathetic investment by anyone 's standards, it is still better than losing everything, including the original amount invested.

TIP

It's important to determine the level of risk you are willing to accept. Decide what the risks are to your investment, evaluate these risks, and decide whether or not you are prepared to accept the risks.

Think of the concept of risk and return as a footrace in which stocks are the runners and the course has lots of potholes. All the stocks are trying to make their way to the finish line (payoff). The younger , lighter, less-established stocks certainly move faster toward the finish line, but they stand substantially more chance of getting tripped up by a pothole. The older, heavier, and more established stocks don't move as quickly, but when those potholes come up it's going to take a pretty deep one to make the stock slow down, and an even deeper one to make the stock stop altogether.

So why bother to take chances at all? Because risk and return are directly correlated to one another. The less risk you take, the less chance you have to make a profit, or capital gain, as depicted in the following illustration:

Figure 11.1. The relationship between risk and return.

On the far left is the kind of return that is absolutely safe, such as putting the money under your mattress rather than investing it. Notice that this return is at the bottom of the risk indicator, or the left side of the table ”this means no risk. Handling your money this way ensures that you will never lose it ”at least not in the stock market. Notice also that the line is at the bottom of the gradual rise indicating return. This means there is also no return on your money. After all, mattress companies don't pay interest on the money you stuff into their products. You would be better off putting that money into the mattress company's stock.

Here's the catch stock investments don't really work this way, not in direct correlation, anyway. There are those investments that have no practical risk to speak of. For example, if you invested in a U.S. Government Treasury bond, you would still earn a little interest, say 5 to 6 percent. The risk of losing your money would be little, if any, because those bonds are backed by the full faith of the U.S. Govern -ment. I suppose the U.S. Government could go out of business, but if it did, you'd have bigger problems than your investments to think of. So, you're making some return, with no "practical risk."

In addition, stories abound about the other side of the coin: those highly risky investments that didn't pay off at all and that, quite truthfully, never stood a chance from the beginning. My brother hits me up all the time with such gems as a company that has developed the first oatmeal- powered car, the launch of television's 24- hour Golf Network, and instant beer (just add water!).

Knowledge Reduces Risk

The hard-and-fast rules of risk versus return aren't quite true. That being the case, it would appear that all bets are equal in the case of risk. A big, solid company might just skyrocket in value, while (quite often) a risky company goes out of business and its investors lose everything instead of making fortunes. Fortunately, this also is not the case. The power to determine risk isn't in any set formula but rather in what you know about what you are getting into. For example, as much as I like beer, the prospect of powdered beer just doesn't appeal to me. In my mind, I wouldn't buy it, so I'll assume that no one else will either and therefore I won't invest in my brother's recommendation.

On the other side of the coin, AOL was already an established company when it decided to merge with Time Warner. Although AOL was one of those "big companies" mentioned earlier, it would be safe to assume that any growth from AOL stock would be minimal, since the risk of AOL going out of business anytime soon is also minimal. How-ever, events proved that this simply wasn't the case, because the merger drove the price of AOL through the roof.

As a side note, the rumor that mergers always make the price of a stock shoot through the roof isn't necessarily true either.

TIP

It is generally accepted that when two companies merge, the price of the bigger company's stock will initially drop while the stock price of the company being overtaken will go up. The price of the newly combined stock is expected to rise after that, making the stock particularly attractive to investors.

But the power to determine the amount of risk and return in any investment rests solely on the investor's shoulders and is directly related to the amount of research he or she is willing to make before investing. Therefore, make sure you know all the risks of any investment you are considering. In addition to the basic risk of the company going out of business, several other risks are particularly insidious and should also be considered . The most common risks for you to consider regarding your own potential investment are

Inflationary risk
Political/governmental risk
Market risk

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