Investing in the stock market (or most any other type of investing) should be about risk and reward.
Risk and reward are two fundamental considerations when investing in the stock market since their relationship tells you how much of a reward to expect for a particular amount of risk.
At its simplest, the risk-reward relationship says for X amount of risk, an investor should expect Y amount of reward.
The more risk that an investment won’t succeed, the higher the potential reward for the investor.
For example, U.S. Treasury issues (bills, notes, bonds) are considered the safest investment in the world since they are backed by the full faith and credit of the U.S. Government.
If an investor can earn 4% from a Treasury issue that is completely safe, what should the investor expect to earn by investing in a stock.
In other words, what is the chance the stock will not be a good investment and the investor could not only fail to achieve an investment goal, but could also lose money.
The risk premium is the amount over what could be earned on a U.S. Treasury issue. If you can earn 4% on a Treasury issue, investing in a solid large company might bring a risk premium of 50%, meaning you should expect to earn at least 6% from the investment.
Most of the time the market makes this calculation for you.
Unfortunately, this process doesn’t work very well when the market is very hot or very cold. Market influences can push a stock price up or down in these conditions that may be unjustified.
In addition, if a stock is in a particularly hot sector (think tech stocks during the dot com boom), its price can be grossly distorted and, therefore the risk-reward formula fails.
It is important to look at a stock’s price in the context of its risk-reward potential, however other factors can distort the formula.
When considering an investment, look beyond the stock to the market and the economy and include those considerations.
In the next article, I will discuss the different types of risk you need to know.
Ask questions and question assumptions.