Concept of Risk vs. Reward

Evaluation of Customers - Concept of Risk vs. Reward

Measuring Portfolio RisksOne of the concepts used in risk and return calculations is standard deviation which measures the dispersion of actual returns around the expected return of an investment. Since standard deviation is the square root of the variance, this is another crucial concept to know. The variance is calculated by weighting each possible dispersion by its relative probability (take the difference between the actual return and the expected return, then square the number).

The standard deviation of an investment's expected return is considered a basic measure of risk. If two potential investments had the same expected return, the one with the lower standard deviation would be considered to have less potential risk.

Risk MeasuresThere are three other risk measures used to predict volatility and return:

• Alpha - this measures stock price volatility based on the specific characteristics of the particular security. As with beta, the higher the number, the higher the risk.
  
• Sharpe ratio- this is a more complex measure that uses the standard deviation of a stock or portfolio to measure volatility. This calculation measures the incremental reward of assuming incremental risk. The larger the Sharpe ratio, the greater the potential return. The formula is: Sharpe Ratio = (total return minus the risk-free rate of return) divided by the standard deviation of the portfolio.
  
• Beta - this measures stock price volatility based solely on general market movements. Typically, the market as a whole is assigned a beta of 1.0. So, a stock or a portfolio with a beta higher than 1.0 is predicted to have a higher risk and, potentially, a higher return than the market. Conversely, if a stock (or fund) had a beta of .85, this would indicate that if the market increased by 10%, this stock (or fund) would likely return only 8.5%. However, if the market dropped 10%, this stock would likely drop only 8.5%.
  
• Learn how to properly use beta to help meet your portfolio's risk criteria in the article, Beta: Gauging Price Fluctuations.

Asset Allocation
In simple terms, asset allocation refers to the balance between growth-oriented and income-oriented investments in a portfolio. This allows the investor to take advantage of the risk/reward tradeoff and benefit from both growth and income. Here are the basic steps to asset allocation:

1. Choosing which asset classes to include (stocks, bonds, money market, real estate, precious metals, etc.)
2. Selecting the ideal percentage (the target) to allocate to each asset class
3. Identifying an acceptable range within that target
4. Diversifying within each asset class

If you are unfamiliar with asset allocation, refer to the tutorial: Asset Allocation.

Risk ToleranceThe client's risk tolerance is the single most important factor in choosing an asset allocation. At times, there may be a distinct difference between the risk tolerance of a client and his/her spouse, so care must be taken to get agreement on how to proceed. Also, risk tolerance may change over time, so it's important to revisit the topic periodically. 

Time HorizonClearly, the time horizon for each of the client's goals will affect the asset allocation mix. Take the example of a client with a very aggressive risk tolerance. The recommended allocation to stocks will be much higher for the client's retirement portfolio than for the money being set aside for the college fund of the client's 13-year-old child.

Read more: http://www.investopedia.com/exam-guide/finra-series-6/evaluation-customers/risk-reward.asp#ixzz1yhz7GZFU

Risk-Return Tradeoff

Definition of 'Risk-Return Tradeoff'

The principle that potential return rises with an increase in risk. 

• Low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential returns. 
• According to the risk-return tradeoff, invested money can render higher profits only if it is subject to the possibility of being lost. 

Investopedia explains 'Risk-Return Tradeoff'

Because of the risk-return tradeoff, you must be aware of your personal risk tolerance when choosing investments for your portfolio. 

• Taking on some risk is the price of achieving returns; therefore, if you want to make money, you can't cut out all risk. 
• The goal instead is to find an appropriate balance - one that generates some profit, but still allows you to sleep at night.

Read more: http://www.investopedia.com/terms/r/riskreturntradeoff.asp#ixzz1yNTT4zyp

Every Choice Comes with Risk

by Michele Cagan, CPA

In the investment world, you'll have to walk a delicate (and very personal) balance between risk and reward. The more uncertain the investment, the greater the risk that your investment won't perform as expected, or even that you'll lose your entire investment. Along with greater investment risk, though, comes an opportunity to earn greater investment returns. If you're uncomfortable with too much risk and seek to minimize it, your trade-off will be lower investment returns (which can be a form of risk in itself). Truthfully, you can't completely eliminate risk. If you don't take any risk at all, you won't be able to earn money through investing.

Investment risk is directly tied to market volatility — the fluctuations in the financial markets that happen constantly over time. The sources of this volatility are many: interest-rate changes, inflation, political consequences, and economic trends can all create combustible market conditions with the power to change a portfolio's performance results in a hurry. Ironically, this volatility, by its very nature, creates the opportunities for economic benefit in our own portfolios, and that is how risk impacts your investments and your investment strategy.

There are many different types of risk, and some are more complicated than others. The 7 risk classifications you'll learn about here are those you'll likely take into consideration as you begin to design your portfolio.

Stock Specific Risk

Any single stock carries a specific amount of risk for the investor. You can minimize this risk by making sure your portfolio is diversified. An investor dabbling in one or two stocks can see his investment wiped out; although it is still possible, the chances of that happening in a well-diversified portfolio are much more slender. (One example would be the event of an overall bear market, as was seen in the early 1990s.) By adding a component of trend analysis to your decision-making process and by keeping an eye on the big picture (global economics and politics, for example), you are better equipped to prevent the kinds of devastating losses that come with an unexpected sharp turn in the markets.

Risk of Passivity and Inflation Rate Risk

People who don't trust the financial markets and who feel more comfortable sticking their money in a bank savings account could end up with less than they expect; that's the heart of passivity risk, losing out on substantial earnings because you did nothing with your money. Since the interest rates on savings accounts cannot keep up with the rate of inflation, they decrease the purchasing power of your investment over time — even if they meet your core investing principle of avoiding risk. For this somewhat paradoxical reason, savings accounts may not always be your safest choice. You may want to consider investments with at least slightly higher returns (like inflation-indexed U.S. Treasury bonds) to help you combat inflation without giving up your sense of security.

A close relative of passivity risk, inflation risk is based upon the expectation of lower purchasing power of each dollar down the road. Typically, stocks are the best investment when you're interested in outpacing inflation, and money-market funds are the least effective in combating inflation.

Market Risk

Market risk is pretty much what it sounds like. Every time you invest money in the financial markets, even via a conservative money-market mutual fund, you're subjecting your money to the risk that the markets will decline or even crash. With market risk, uncertainty due to changes in the overall stock market is caused by global, political, social, or economic events and even by the mood of the investing public. Perhaps the biggest investment risk of all, though, is not subjecting your money to market risk. If you don't put your money to work in the stock market, you won't be able to benefit from the stock market's growth over the years.

Credit Risk

Usually associated with bond investments, credit risk is the possibility that a company, agency, or municipality might not be able to make interest or principal payments on its notes or bonds. The greatest risk of default usually lies with corporate debt: Companies go out of business all the time. On the flip side, there's virtually no credit risk associated with U.S. Treasury-related securities, because they're backed by the full faith and credit of the U.S. government. To measure the financial health of bonds, credit rating agencies like Moody's and Standard & Poor's assign them investment grades. Bonds with an A rating are considered solid, while C-rated bonds are considered unstable.

Currency Risk

Although most commonly considered in international or emerging-market investing, currency risk can occur in any market at any time. This risk comes about due to currency fluctuations affecting the value of foreign investments or profits, or the holdings of U.S. companies with interests overseas. Currency risk necessarily increases in times of geopolitical instability, like those caused by the global threat of terrorism or war.

Interest Rate Risk

When bond interest rates rise, the price of the bonds falls (and vice versa). Fluctuating interest rates have a significant impact on stocks and bonds. Typically, the longer the maturity of the bond, the larger the impact of interest rate risk. But long-term bonds normally pay out higher yields to compensate for the greater risk.

Economic Risk

When the economy slows, corporate profits — and thus stocks — could be hurt. For example, political instability in the Middle East makes investing there a dicey deal at best. This is true even though much of the region is flush with oil, arguably the commodity in greatest demand all over the planet.

http://www.netplaces.com/investing/designing-your-personal-portfolio/every-choice-comes-with-risk.htm

What is Risk?

Risk  is incorporated  into  so many  different disciplines from insurance to
engineering  to  portfolio  theory  that it should  come as no surprise that it is defined  in
different ways by each one. It is worth looking at some of the distinctions:

a. Risk versus Probability: While some definitions of risk focus only on the probability
of an  event occurring, more comprehensive definitions incorporate both  the
probability  of the event occurring and  the consequences of the event. Thus, the
probability  of a severe earthquake may  be very small but the consequences are so
catastrophic that it would be categorized as a high-risk event.

b. Risk versus Threat: In some disciplines, a contrast is drawn between risk and a threat.
A threat is a low probability  event with very  large negative consequences, where
analysts may be unable to assess the probability. A risk, on the other hand, is defined
to  be a higher probability  event, where there is enough  information  to  make
assessments of both the probability and the consequences.

c. All outcomes versus Negative outcomes: Some definitions of risk tend to focus only
on  the downside scenarios, whereas others are more expansive and  consider all
variability as risk. The engineering definition of risk is defined as the product of the                                               

probability of an event occurring, that is viewed as undesirable, and an assessment of
the expected harm from the event occurring.

Risk = Probability of an accident * Consequence in lost money/deaths

In contrast, risk in finance is defined in terms of variability of actual returns on an
investment around  an  expected return, even  when  those returns represent positive
outcomes.



Risk and Reward
The “no free lunch” mantra has a logical extension. Those who desire large
rewards have to be willing to expose themselves to considerable risk. The link between
risk and return is most visible when making investment choices; stocks are riskier than 
bonds, but generate higher returns over long  periods. It is less visible but just as
important when making career choices; a job in sales and trading at an investment bank

may be more lucrative than a corporate finance job at a corporation but it does come with
a greater likelihood that you will be laid off if you don’t produce results.

Not surprisingly, therefore, the decisions on how much risk to take and what type
of risks to take are critical to the success of a business. A business that decides to protect
itself against all risk is unlikely to generate much upside for its owners, but a business
that exposes itself to the wrong types of risk may be even worse off, though, since it is
more likely to be damaged than helped by the risk exposure. In short, the essence of good
management is making the right choices when it comes to dealing with different risks.






http://people.stern.nyu.edu/adamodar/pdfiles/valrisk/ch1.pdf

A stock price must past 2 tests to be considered reasonable.

The most important task in buying a stock is to determine that the company is a good company, in which to own stock for the long term. 

However, no matter how good the company, if the price of its stock is too high, it's not going to be a good investment.

A stock price must pass two tests to be considered reasonable:

1.  The hypothetical total return

The hypothetical total return from the investment must be adequate - enough to contribute to a portfolio average of around 15 percent - sufficient to double its value every 5 years.

2.  The potential risk 

The potential gain should be at least 3 times the potential loss.




























To complete these tests, you have to learn how to do the following:

• Estimate future sales and earnings growth
• Estimate future earnings
• Analyse past PEs (check the present PE relative to its usual average PE)
• Estimate future PEs.
• Forecast the potential high and low prices
• Calculate the potential return.
• Calculate the potential risk.
• Calculate a fair price.

Reward-to-Risk Ratio -The Basics

This video will outline the concept of Reward-to-Risk.

Teach you the 3 components you must have to calculate your RR.

Trading "Math" (Win% + RR) I hit you with the numbers! How the relationship between your RR and how often you win affects your trading.

Slide after slide of examples and figures that is going to blow your mind if you were unaware of the power of this concept.