Risk Assessments

Risk is an inherent factor when investing. However, different levels of risk are appropriate for different situations and investments. This article aims to instruct on appropriate risk depending on the situation. 


In the context of investing, risk refers to the possibility of losing capital. If an individual takes more risk or has a more aggressive investing strategy, they have the potential to lose more capital. If an individual takes less risk or has a more conservative investment strategy, they jeopardize less of their capital. 


There are no fixed levels of risk - it is an abstract and qualitative concept. However, the People’s Capital team has created three broad "risk scenarios" to help our subscribers and guests become familiar with the concept of risk and how it relates to capital.  


High Risk


At People’s Capital, we classify an investment as high risk when an investor believes there is a reasonable chance the asset could permanently lose 40%-100% of its value. Of course, there is always the chance that any security an investor purchases could become worthless, but this is highly unlikely with well-established securities. 


A small position size, or portion of one’s portfolio to invest in a position, is appropriate for high-risk investment. Small positions are typically considered to be less than or equal to three percent of an individual's portfolio. 


When an investor makes a high-risk investment, they must have a high level of conviction that their investment will behave favorably. Thus, the investor must go above and beyond to research and understand the investment and have good reasons that support a strong conviction that the security will move favorably. 


Examples of a high-risk investment include but are not limited to buying naked call options and using leverage (debt) to purchase securities. A specific example is provided below. 


Investor A has a $10,000 portfolio and a conviction that Advanced Micro Devices (NASDAQ: AMD) will rise significantly shortly. They know their computer processors are years ahead of their leading competitor Intel (NASDAQ: INTC) and believe the market has undervalued AMD's technological advantage. Furthermore, other popular semiconductor companies have all risen in recent weeks, and AMD’s stock price has remained relatively flat. Investor A decides to act on this information and purchases one call option, at the money, for AMD stock that expires in 14 months for $300 (3% of their portfolio).


Moderate Risk


People’s Capital classifies a moderate risk level investment if the investor believes there is a reasonable chance the asset could permanently lose 20%-40% of its value.


An appropriate position size for a moderate-risk investment is somewhere between 3 and seven percent of an investor's portfolio. 


Moderate risk level investment still requires a high level of conviction from the investor. The investor must have gone above and beyond to research and understand the prospective position. They should have good reasons that support a strong conviction about the favorability of the stock.


Examples of moderate-risk investments include purchasing small and mid-cap stocks, purchasing stocks that recently IPOed, and some volatile ETFs. For instance:


Under Armour (NYSE: UAA) recently had a change in leadership. Poor management and executive leadership plagued the company for many years, but the new CEO demonstrates promise. Investor A believes that Under Armour has excellent products, and new corporate leadership focused on mending the company’s premium image will mark the path back to profitability. The stock is also dirt cheap after the first wave of the pandemic in April of 2020. Investor A capitalizes on this opportunity to purchase the midcap Under Armour stock for $10 per share. 


Low Risk


People’s Capital classifies a low-risk level investment if the investor believes there is a reasonable chance the asset could permanently lose 0%-20% of its value.


It is appropriate to allocate a large portion of one’s portfolio - up to ten percent - to low-risk investment. 


Low-risk investments do not require the same level of conviction as high-risk and moderate-risk investments. An investor still needs to have reasons they believe the stock will do well and have done significant research to understand the investment. However, for a lower-risk investment, the investor does not need to do as much research or have as strong a conviction.


Examples of low-risk investments include purchasing blue-chip stocks (large companies), stable ETFs, and U.S. Government bonds. For instance:


Investor A wants to add more tech to their portfolio. Apple (NASDAQ: AAPL) has underperformed the market in the past several weeks, and investor A thinks it is a strong investment in the long term. Investor A buys shares of Apple on a five-year investment horizon. 


Risk vs. Reward 


Finance is a lot like life. The more risk you are willing to take, the more reward you could POTENTIALLY receive. For example, let's say you bet your entire portfolio on a highly leveraged speculative position - the finance equivalent of a lottery ticket. You COULD become a millionaire with just $500. However, it is far more likely that you will lose all of your capital. The trick to investing is balancing risk vs. reward. You want to take enough risk so that you can make decent returns, but not so much that you jeopardize all your money. The balance is different for everyone, and as an investor, you need to develop a sense of how much risk you are willing to take. 


Risk and Age 


When an individual is young, they can take more risk, because they have more time to recover from losses. Their future earnings can offset potential losses. When a person is farther into their life, they have less time to recover from losses, and they have already earned more of their lifetime earnings. Thus, they need to take less risk to protect their wealth.