13th April 2012
That is why, when investors discuss possible stock ideas, people often like to focus on stocks with lots of potential upside, that's why one hears so much talk about a company that is ‘500% cheap' or might go up 10 times in value – the proverbial '10-bagger'.
However that, unfortunately, is where the conversation often ends. There is probably an underlying assumption such an excess of upside inherently involves some risk but that is rarely quantified. So, of course, if I were to say I have unearthed one of those 10-baggers – a stock I believe could go up 1,000% – you will in all likelihood be very keen to know its identity.
However, what if I then add I have one other piece of information – there is also a 99% chance when the market opens tomorrow morning the company will go bust? Are you still interested? All of a sudden, most people are not. That one piece of information completely changes how they think about the potential upside.
This illustrates a big problem for many investors – it is easy enough to focus on the upside or even the downside but more difficult to consider both in tandem. Let's take the other side of this evaluation, the risk. What if I were to ask about the suitability of Royal Bank of Scotland (RBS) as an investment? Many people would say avoid UK banking because it's too risky.
To be fair, that is not a completely unreasonable view, but of course the proper response to my question should be – at what price? Yes, RBS brings with it a number of risks as an investment but at what price are investors compensated for taking on those risks? That, to a greater or lesser extent, is the job of a fund manager – after all, what else are we paid to do other than to try and appraise risk versus reward?
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