ValuFocus Investing: A Cash-Loving Contrarian Way to Invest in Stocks

Chapter 28

Incorporating Risk into Our Model

Successful equity investors work hard to understand and account for the risks inherent in their decisions to buy, hold, and sell certain stocks and manage their portfolios.

Risk and return work together. All stocks carry risk. Indeed, there is more risk involved in stock investing than most other instruments. Pick a safe certificate of deposit from a bank, guaranteed by the federal government, and your return likely will be less than it will from a stock, at least when the market is going good and over the long haul. Think of the return from the stock as your reward for taking the risk. With stocks, there are higher levels of uncertainty.

Risk is half of the equation in the risk/return ratio that has guided investors in making stock buy/hold/sell decisions. Smart investors and students of investing always have preached that assessment of risk should be just as necessary and is as valuable as decisions on which stocks to hold in your portfolio. Sometimes, it seems that investors throw risk considerations aside in their zeal to optimize returns farthest and fastest.

Risk is a huge factor in return outcomes. Really effective risk analysis should lead to a higher return. At those times when the market is charging full speed ahead, risk seems less useful; high returns will result anyway. But studies show that better risk analysis would have produced results even higher than those achieved.

And risk during the tough times in the market can ...