Investment: Why Focusing On Risks Rather Than Rewards Is Important
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Unfortunately, many investors pour all their efforts into maximizing returns. Of course, that is indeed the ultimate goal, but it is not the right mindset to have. Instead, the focus should be on managing risk in order to achieve those positive returns.
Benjamin Graham, an economist, professor, and investor once said “The essence of portfolio management is the management of risks, not returns”. The outcome of effective management of risk in the financial world is known as Positive Asymmetric Risk Reward.
The two diagrams below compare the two scenarios of positive asymmetric risk reward versus negative asymmetric risk reward. The former is the case where you can only lose an amount that is smaller than the potential reward (and the latter is the opposite case).
Investment Vehicles For Maximum Returns and Minimum Risks
The tendency during bull markets is an even greater focus on returns rather than risk and even though we are currently possibly entering a bear market, investors are still unlikely to shift their mindset and continue focusing on returns for some time yet. Discussions tend to revolve around topics such as yields, returns, dividends, coupons, etc., all of which are clues that returns are getting more focus than any real details of risk.
Asymmetric risk reward situations with positive outcomes can be determined when we focus on both risks and returns. To limit the downside risk, you can look at measures of financial performance including financial ratios such as the price to book ratio or the return on equity. A factor to also work in to your analyses is growth stocks because a company that has a high probability of sustained gains in the longer term can potentially lead to bigger profits than stock with relatively high debt. The high probability of strong gains will most likely be due to macro trends or positive industry factors.
Stocks and Bonds
Stocks have been jumpy due to the pandemic, but as the economy recovers, now could be a good time to invest in shares. As the economy is expected to grow at 5.8% and the current S&P 500 Earnings Yield is at 2.51%, a simple calculation yields a positive asymmetric risk reward potential. However, diversification is key in order to maintain this positivity.
Bonds tend to have little appeal except as low-risk diversifiers. But even that role is at risk because of fragile economies. There is still a place in a portfolio for bonds if you aim for ones issued by lower-risk emerging markets governments. The Chinese benchmark 10-year government bond, for example, currently has a yield above 3%.
Applying Positive Risk Reward Asymmetry To Your Portfolio
The potential for discovering investments that demonstrate a high positive risk reward asymmetry is very significant considering there are thousands of companies around the world. You need to analyze indicators limiting the downside and indicators increasing the upside for those companies.
Indicators Limiting The Downside
- book value
- stable cash flow
- cash per share
- zero or minimal debt
Indicators Increasing The Upside
- high potential earnings
- solid management structure
- adaptability to the markets and ease in which the company can move into new markets as and when necessary
- effectiveness of the use of company assets
In addition, investors need to look at company growth (past and potential long-term sustainable future growth). They would do this by looking at the macro or demographic trends for the market and industry that the company specializes in.
Investors need to deploy a mix of fundamental analysis (which is essentially analyzing the above indicators) and technical analysis (looking at historic stock prices and other patterns) to weed out companies listed on stock market indexes (such as the S&P 500 for USA companies and the STOXX Europe 600 index for European companies) with a high probability of long term sustainable growth.
Such analyses involve great vision, investment in time, dedication and experience. Fortunately, experts possessing all of this and more, and with an ability to see through all the political and economic uncertainty do exist. For example, Chris MacIntosh, founder of Capitalist Exploits, is such a person. Chris has an enviable track record and has built up a series of highly successful real estate businesses and investment funds starting from a very young age.
