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

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