Thursday, 27 October 2011

Managing investment risk-taking

Business Mirror

YOU cannot acquire financial security today through earned income; the only way you do it is by owning an appreciating asset.

That seems reasonable enough. So why do most people work and earn and spend but never become wealthy or fully financially secure. One word: risk.

To say it simply, without risk there can be no reward. Most of us experience through life that often, the greater the probable reward, the greater the potential risk. The Greek historian Herodotus wrote 2,500 years ago that, “Great deeds are usually wrought at great risks.”

Very often though, we prefer to take the easier way out, because we do not want to face the challenge of risk taking.

However, not taking risks is not the best or even a sensible course of action. The Cuban marathon runner, Alberto Salazar said, “If you want to achieve a high goal, you’re going to have to take some chances.” And German philosopher Friedrich Schiller wrote, “He that is over-cautious will accomplish little.”

The questions we must answer are, how do we psychologically handle risk taking before we invest and then, how do we manage the risks involved in our venture. It is really only one question that requires a two-part process.

The Greek philosopher Plato laid the foundation for the first question: “Courage is knowing what not to fear.”

Some people believe that investing in the stock market is something they could never do because of the high risk. However, those same people know that others have made fortunes in the market. The first step is knowing what not to fear.

While we intellectually know that the stock you buy is not going to go to zero five minutes after you buy it, emotionally, we believe it could happen and our investment would be wiped out. It is tough to tell your emotions that they are wrong, so let’s assume “zero” could happen.

The first way to overcome the fear of “zero” is to invest an amount that even if you lose it all, your lifestyle would not be damaged. Why do we buy lotto tickets knowing that the chances of losing are very, very high? Because the P10 or P20 that we spend for a ticket would not financially affect us. So then it only makes sense to put at risk what we can afford to lose even if we know that we will not lose it all.

Megaworld (MEG), a large blue-chip stock, was up a net 12 percent last week. A 12- percent weekly return is more than your bank deposit pays in a year and this is not some rumor-driven speculative issue.

How much risk are you willing to accept for a 10- percent weekly return? Let’s make it a 50/50 proposition; you are willing to lose 10 percent to gain 10 percent.

You could have bought MEG at the close on October 16th for P1.71 per share. You could have sold it at the close one week later for P1.92. If you only wanted to risk 10 percent, then you would have made sure of cutting your position if the price dropped to P1.55. The lowest price MEG hit last week was P1.73.

The way to psychologically handle the risk is to decide before you place the investment specifically and exactly what your cut-loss point will be and stick to it without wavering. That way, we know the risk involved and we know how to manage the risk.

It is not real life. Looking back a week ago and seeing MEG go up is not the way things work. Sorry, but it does work that way.

It is important to remember that two factors go into an investment and that we usually only look at one. The American writer Elbert Hubbard said, “The man who knows it can’t be done counts the only risk, not the reward.”

On October 16th I wrote to my web-site subscribers that the potential risk of buying MEG at P1.71 per share was 6 percent or a drop to P1.60. The probable profit was at P1.84 or a 6-percent risk and an 8-percent profit. The weekly trend of the price was “Buying.”

Another issue with a “Neutral/Buying” trend had less than 1-percent risk because any decline was a cut-loss point and a 20-percent reward potential. The stock went up 24 percent and never traded lower than the opening buying price.

Managing stock-market investment risk is simple if you know going in what both the downside and upside potential is.

Managing risk and reward is about minimizing risk and maximizing profits. If you avoid potential risk, you avoid potential reward.

E-mail to and Twitter @mangunonmarkets. PSE stock-market information and technical analysis tools provided by Inc.

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