Evaluating Risk versus Reward in Stock Analysis

One of the biggest mistakes people make when investing in a stock is failing to consider the stock's potential risk versus reward. Oh sure they fantasize about the upside while dismissing any thought of a serious decline in the stock. Other more prudent investors think they are being sagacious by purchasing "safe" blue chip stocks like Bank of America, Procter & Gamble which will protect them from a declining market. what these investors forget. Unfortunately these investors have seen there supposedly safe stocks fall by large amounts   In this article I will postulate that purchasing safe stocks with limited upside is the most dangerous kind of investment and that it would be safer for investors to set aside 20-30% of their portfolio in a basket of 20-30 high-risk high-reward small cap stocks.

The line of reasoning behind risk/reward analysis is that a stock's potential reward (appreciation) should greatly out way its risk (substantial decline) by a large margin. Why? Because when you invest in a stock (or even index fund) you are assuming a major risk that you could permanently lose your investment capital. I know that this is somewhat of a controversial statement to some investment advisers who believe that stocks always do well over the long term and that you should assume 10% stock appreciation. However as most investors have learned the hard way over the last decade it is not your divine right to 10%+ returns in the stock market. Many investors thought buying big blue chip stocks like Citigroup, AIG, or Enron would be a conservative way of protecting their capital and providing a decent and reliable return. I would argue that contrary to their intentions these investors were actually recklessly gambling because they forgot to consider the risk/reward that these stocks presented. When you purchase large (above 50 billion market cap) stocks like I previously mentioned you know that you will never achieve large returns (3-10X) and at the very most will likely receive 7-15% per year. Even these returns are only achievable if the general stock market itself rises. So you can see that the upside to these stocks is severely limited and this assumes favorable market conditions.

Now lets consider the downside (risk) of these type stocks. You will have noticed that over the last 10 years there have been two occasions where the market itself has fallen by approx 50% which took down all stocks with it. We have also witnessed formerly reliable companies like Citigroup and AIG fall 90%+ in less than a 1 year.  If you look at a chart of almost any stock over the last 10 years you will see that it has had at least 1 period where it fell at least 50%. I realize that there always the exception but my point is that stocks often have the ability to fall significantly for no other reason than the general market did. So when considering the downside risk of a stock I like to assume that any stock has the potential to fall between 50-70% and the worst case 100%. I realize that some may argue that this is a purely arbitrary assumption that cannot be relied upon but I would counter that investors should always assume the worst so that can prepare for it and not be shocked and panicked when it does occurs. After all no professional analyst thought it was possible for Citigroup, Bank of America, etc to fall as much as they did. i remember an analyst who thought Citi was a buy in 2007 at 55 and had a price target of 65 based on "strong fundamentals." So lets consider the risk/reward in this case: the upside is 10 dollars or 20% and the downside is assuming 50% is 27.5 points. Would you invest with these kind of odds? I certainly would not because it does not present a favorable risk/reward.

One important thing to remember regarding risk/reward analysis is that it is entirely subjective. You ask 10 different people to analyze the risk/reward of a company like Apple and you will probably get 10 different responses. However there are few principles which can help determine a company's true risk/reward. The larger the company (by market cap) the slower the growth rate and as such the lower the capital appreciation potential of the stock. This obviously favors small cap companies because it is much easier for a 50 million market cap company to double than a 100 billion company. Another principle is to be conservative with future estimates and not over exaggerate a company's prospects.

I know at this point you thinking I must be crazy for saying that it is safer to put 20-30% of your portfolio into a basket of  high-risk high-reward micro cap stocks compared to safe blue chips companies. It's an understandable first impression but give me a change to explain the logic. First, I would say that it is important to adequately diversify your micro cap stocks picking say 25-30 companies (from different sectors and industries) so they would only represent around 1-1.5% percent of a portfolio. This will help mitigate the effects of a company blow-up due to unfortunate events, fraud, and mismanagement. Second, this strategy puts the odds of finding a few success in your favor. All you need is 2-3 big winners to offset any losers and then some. To someone like myself this really appeals to me because I do not have to be right very much in order to make a nice return on capital.

So you have heard the advantages of this strategy but it is now important to understand the risks as well. This strategy only works in a rising market--if the market crashes 50% like in 2008 all stocks will drop and micro caps because they are smaller and less liquid will likely fall much more than the market. For example in 2008 junior resources companies fell on average 80-99% regardless of fundamentals. Now some foolish experts (Greenspan, Bernanke, etc) will postulate that 2008 was a 1 in 100 year event that should never be expected to occur again (LOL). Personally I am not satisfied with this conclusion and believe that the stock market could easily fall 50% again in the next few years. So the question is how to know when it is safe to buy these micro/small cap stocks? Generally speaking when the S&P 500 is above its 200 day moving average the market is in a bull market and below it is in a bear market. So as long as the market sustains the bull market (above 200 day) it would be all right to maintain this strategy.

One other consideration with regards to this strategy is obviously stock selection. Theoretically an inexperienced (or simply unlucky) individual could pick 25-30 losers and sustain a large loss for his overall portfolio. This is why the only person who could attempt this strategy would be someone who has the time and inclination to do the research on individual companies. Believe me is is quite tedious finding information regarding these companies because there are no analyst reports or anything. You have to do your own primary research surveying the general industry including competition, regulatory problems, and other variables.

In conclusion I am not telling anyone to do implement strategy but hope to help investors by showing them how to apply risk/reward analysis to stock investments. As we have seen bigger and safer stocks recommended by investment advisers are not as risk free as they would like you to believe. Even indexes like SPY can and do fall 50% and rarely offer an attractive risk versus reward to most investors. The only talk of potential risk/reward that I have ever read relates to active traders and not investors. I think it is a valuable tool in evaluating stocks rather than the usual technical and fundamental analysis.

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