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Financial Literacy

How To Define and Distinguish If One Investing Opportunity Is Better Than Another

How do you define “good investments?” How do you know if one particular investment opportunity is better than another? What are the important factors to consider when deciding whether an investment is “good” or “bad?”

Specifically, what do you need to know?

Let’s cut to the core: The lower the risk and the higher the expected return, the better the investment.

Of course, that sounds simple, until you try to define both the risk and the expected return and then you try to compare whatever you come up with to other investment options. It’s difficult because we just can’t compare the risk and return very easily across different assets, or can we?

How To Make a Valid Comparison of Good and Bad Investments

The truth is, we CAN make an apples-to-apples comparison of investments by simply coming up with a ratio of reward versus risk. To get this ratio, we merely need to look at the performance of various indexes over a consistent period of time. And we need to adjust their returns for risk-free interest. (If we didn’t adjust for risk-free interest, Treasury Bills would have the highest score, with a return of about 6% and a risk – or volatility – of only 2% a year.)

So to compensate, I’ve adjusted the return of each index down by 6% – that’s the figure in the adjusted return column in the chart below. As you will see, by compensating for risk-free interest, the score for Treasury Bills immediately falls to the bottom of the list.

Score Return Adjusted Return Volatility Investment
0.87 19.5 13.5 15.4 Dow Stocks
0.59 11.2 5.2 8.9 Corp. Bonds
0.57 9.9 3.9 6.9 Treasury Bonds
0.50 13.7 7.7 15.4 Real Estate Stocks
0.41 14.1 8.1 20.0 Russell 2000
0.39 15.0 9.0 23.0 International Stocks
0.11 6.2 0.2 1.9 Treasury Bills

Now that you’ve had a chance to see how the various investment categories stack up, I’ll try to explain – as clearly and simply as possible – how the comparisons were made.

What the Scoreboard Means

To begin, the “score” is the ratio between the adjusted return and volatility columns in the table. But in reality, it’s also the reward versus risk ratio I mentioned earlier. And it allows us to compare apples to apples and potentially differentiate good investments from bad.

What’s interesting when you check out the scoreboard is that international stocks – which had the second-highest return – end up second from the bottom of this list because their risk (volatility) is so high. In fact, they’re the riskiest investment on the scoreboard.

It’s also interesting that corporate bonds – relatively boring to most investors – come in second, even without having one of the highest rates of returnall because their risk is so relatively low.

Investors Seem To Be Flocking To…

People tend to be attracted to risk. They buy international stocks. And they buy tech stocks – the riskiest of all (and about three times as risky as stocks in general). I don’t know if people haven’t seen a table like this before, or if they just don’t want good-but-boring investments like timber or decent corporate bonds, for example.

But when you take the time to compare the risk-reward ratios of different investments – in much the same way you would compare features of new luxury cars before purchasing – you give yourself a much clearer understanding of what to expect for your money.

As we proved here, it’s easy to find out just how much return you can expectand just how many sleepless nights you’ll have along the way.

One more important thing to note: we only used 18 years worth of data in this chart, and that’s probably not enough. If you just invested based on this table, you’d buy big U.S. stocks right now and shun small stocks, which could be a dangerous move. The table and the comparisons are only as good as the data used.

What Reward-to-Risk Ratio is Right for You?

The key message here is that, when you evaluate any investment, you’ve got to consider both expected return and risk. Most people, dreaming about big potential returns, forget about the second variable – risk. Don’t include yourself in that list.

Before making an investment, ask yourself: “How much risk am I really taking, and what is my upside?” For me, personally, I like to have a three-to-one reward-to-risk ratio. If I can’t potentially make three times whatever I have at risk in a stock, it’s not worth it.

The Trailing Stop Strategy

Let me explain this concept a little further. I use a trailing stop on all stocks I invest in, and that trailing stop is generally 25%. That means, if I buy a stock at $100, I’ll sell it at $75 to limit my risk. If I’m willing to risk 25%, then that means I’d better be looking for a return of 75% or more, or it’s not worth buying.

Think about this. If you’re not using trailing stops to protect yourself, you’re actually risking 100% every time you invest. So you’d better be expecting a 300% return. Those odds aren’t good – I can probably count the number of “real” stocks up 300% in the last year on one hand.

If you know your risk – in my case 25% — and your potential return is favorable to you in relation to the risk you’re willing to take, then you’ve got a “good investment.” (Again, in my case, I define that as looking for a 75%+ return on my investment).

Good investing,

Steve

Today’s Investment U Crib Sheet

  • Understanding the reward-to-risk ratio is critical in distinguishing good investments from bad ones, which will ultimately lead to your success. Review the “investment scoreboard” listed above, and see if the investments you’ve been making fall into categories that produce less-than-desirable returns relative to their risk.
  • You should spend just as much time considering the potential risk of any investment you make as you do dreaming about the return. Don’t fall into the trap so many investors do and forget to consider risk until it’s too late.
  • When investing in stocks, you should always use trailing stops to protect yourself and limit your risk. Consider the reward-to-risk ratio you’re most comfortable with, and set your trailing stop accordingly. Remember, if you’re not using trailing stops when investing in stocks, you’re automatically risking 100% of your investment every time.

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