When ignorance is risk

The Motley Fool began as a newsletter and has become one of the most popular personal finance websites. Anyone who follows its philosophy is called a 'Foolish Investor'

One topic most Foolish investors find hard to understand fully is risk. We know that greater rewards tend to come with higher risk, but how should the risk-averse investor minimise it and still find decent investments?

One topic most Foolish investors find hard to understand fully is risk. We know that greater rewards tend to come with higher risk, but how should the risk-averse investor minimise it and still find decent investments?

Suppose you give an equal sum of money to two people to invest for you. You do not know anything about their methods, but later on each gives you back your cash plus the same percentage. Their investment performance seems the same, so maybe the risks they took were the same. Or maybe not.

Imagine one had invested safely in gilts, and the other had struck lucky in a casino. Still think they're equally risky? Deciding between two shares or funds involves similar vagaries, though the choice is not so stark. The way to the answer is by comparing the risk of the alternative investments. Until you know how they make their money, you can't know how the two might compare for long-term performance.

Investors often fail to take risk into account. If you buy shares in a company and they double in price, is that the same kind of investment as someone who does an identical trick with a different set of shares? Probably not, if the risks are not similar. Making a 100 per cent gain in a blue-chip company is not likely to have involved the same risk as doing so in a small biotech company.

The general proposition is that we want maximum reward for minimum risk. Consider money on deposit: ignoring disasters, like the bank going broke, the risk is zero - you can't lose. But all you can ever win is the prevailing interest rate. Once you get into shares to try and generate a higher return than cash, you must accept risk. But it is not always clear just how much risk is attached to any particular share when compared with another.

Risk-conscious investors should try to minimise the down- side risk by insisting on cheap fundamentals (such as relatively low price/earnings). Then, if something goes wrong, the share is likely to fall less than one that is more highly rated.

Suppose you like biotech firms. They're all pretty risky but, ultimately, some are more so than others. What you need is a way to compare relative risk. Common sense, for example, suggests that a company pinning all its hopes on one big idea is riskier than one with a stable of products.

After picking out the companies with the least chance of disaster, move on to the upside potential. The market being what it is - not entirely rational - it may transpire that money-making opportunities are combined with a lower risk than that presented by bio-techs in general. That is the combination to seek.

www.fool.co.uk

Independent Partners; Do you need financial advice on your investments, pension or insurance? Book a free consultation with an independent Financial Adviser at VouchedFor.co.uk

Finacial products from our partners
Property search
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    Recruitment Genius: Sales Assistant / Buyer

    £15000 - £17000 per annum: Recruitment Genius: This company offers a range of ...

    Recruitment Genius: Customer Service Advisor

    £15000 - £16000 per annum: Recruitment Genius: Customer Service Advisors are r...

    SThree: Trainee Recruitment Consultant

    £20000 - £25000 per annum + OTE £45K: SThree: SThree were established in 1986....

    Recruitment Genius: Compliance Manager

    £40000 - £60000 per annum: Recruitment Genius: A Compliance Manager is require...

    Day In a Page

    Greece debt crisis: What happened to democracy when it’s a case of 'Vote Yes or else'?

    'The economic collapse has happened. What is at risk now is democracy...'

    If it doesn’t work in Europe, how is it supposed to work in India or the Middle East, asks Robert Fisk
    The science of swearing: What lies behind the use of four-letter words?

    The science of swearing

    What lies behind the use of four-letter words?
    The Real Stories of Migrant Britain: Clive fled from Zimbabwe - now it won't have him back

    The Real Stories of Migrant Britain

    Clive fled from Zimbabwe - now it won’t have him back
    Donna Karan is stepping down after 30 years - so who will fill the DKNY creator's boots?

    Who will fill Donna Karan's boots?

    The designer is stepping down as Chief Designer of DKNY after 30 years. Alexander Fury looks back at the career of 'America's Chanel'
    10 best statement lightbulbs

    10 best statement lightbulbs

    Dare to bare with some out-of-the-ordinary illumination
    Wimbledon 2015: Heather Watson - 'I had Serena's poster on my wall – now I'm playing her'

    Heather Watson: 'I had Serena's poster on my wall – now I'm playing her'

    Briton pumped up for dream meeting with world No 1
    Wimbledon 2015: Nick Bollettieri - It's time for big John Isner to produce the goods to go with his thumping serve

    Nick Bollettieri's Wimbledon Files

    It's time for big John Isner to produce the goods to go with his thumping serve
    Dustin Brown: Who is the tennis player who knocked Rafael Nadal out of Wimbeldon 2015?

    Dustin Brown

    Who is the German player that knocked Nadal out of Wimbeldon 2015?
    Tour de France 2015: Twins Simon and Adam Yates have a mountain to climb during Tour of duty

    Twins have a mountain to climb during Tour of duty

    Yates brothers will target the steepest sections in bid to win a stage in France
    John Palmer: 'Goldfinger' of British crime was murdered, say police

    Murder of the Brink’s-MAT mastermind

    'Goldfinger' of British crime's life ended in a blaze of bullets, say police
    Forget little green men - aliens will look like humans, says Cambridge University evolution expert

    Forget little green men

    Leading evolutionary biologist says aliens will look like humans
    The Real Stories of Migrant Britain: An Algerian scientist adjusts to life working in a kebab shop

    The Real Stories of Migrant Britain

    An Algerian scientist struggles to adjust to her new life working in a Scottish kebab shop
    Bodyworlds museum: Dr Gunther von Hagens has battled legal threats, Parkinson's disease, and the threat of bankruptcy

    Dying dream of Doctor Death

    Dr Gunther von Hagens has battled legal threats, Parkinson's disease, and the threat of bankruptcy
    UK heatwave: Temperature reaches 39.8 degrees on Central Line - the sweatiest place in London

    39.8 degrees recorded on Tube

    There's hot (London) and too damn hot (the Underground). Simon Usborne braved the Central line to discover what its passengers suffer
    Kitchens go hi-tech: From robot chefs to recipe-shopping apps, computerised cooking is coming

    Computerised cooking is coming

    From apps that automatically make shopping lists from your recipe books to smart ovens and robot chefs, Kevin Maney rounds up innovations to make your mouth water