Have you ever noticed

Have you noticed that posters on finance messages boards almost exclusively post bullish views? Worse yet they shout down anyone sensible enough to venture a fearful scenario.

I wish there were more bearish views.

Fear greed spectrum

For every company there are multiple possible outcomes. Multiple scenarios across the fear-greed spectrum.

When investing it’s good to know and weight at least 3 alternatives. You could go crazy and use a Monte Carlo simulator. But 3 weighted outcomes will do.

So tell me, how many do you consider before buying part ownership in a company? And more importantly what’s your risk return hurdle?

Mine’s 3 to 1. But that’s simply to pique my interest ;-).

For every dollar I consider at risk I look for at least $3 in return. And get excited when I see over $5.

For example, if my fearful scenario for a company is a 50% loss, then the conservatively optimistic scenario has to be a 150% gain. However, these days I prefer lower risk, around 20-30% downside.

I currently have one large position that doesn’t meet my 1 to 3 hurdle. That makes me uncomfortable. Very uncomfortable, so I watch the company closely.

Moving on.

Risk return investing example

I used the following graph to highlight the attractiveness of Telstra Corporation (ASX: TLS) in January 2011. That opportunity had a 1 to 8 risk return!

Telstra was especially attractive due to multiple payoff windows that made it both an excellent short and long time frame investment. Just the type of investment I love, and suggest you look for —  excellent risk return profile and multiple payoff time frames.

Telstra Opportunity in Jan 2011

Using a risk return framework forces me to consider multiple outcomes and to look forward. It provides a rationale mechanism to overcome the noise of fear and greed. It would butter my toast if I let it! Most importantly, it forces me to consider what could go wrong.

Long live the bear.

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  • Hi Dean,

    That’s very interesting. How do you calculate the risk / return matrix?


  • Hi Mike,
    How I determine the risk return range is a long story, which I’m not going to go into now. But, as part of my first run past a company I usually simply use earnings or cash flow multiples to determine my bands, but sometimes it’ll be dividend or sum of parts based. Accuracy doesn’t matter. I’m looking for great opportunities, so if my estimates are out by a long way — which is usually the case 😉 — it’ll still be OK.

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