Understanding Risk & Rewards is The Key to Your Investment Success

Agoraphobia, fear of failure and defeat, is a greater hindrance to success in the stock market than is greed. But in the stock market there also seems to be a fear of success. I can't put my finger on the precise reason it exists, but it does.

All too often investors are snatching defeat out of the jaws of victory. I see it all the time and I'm sure it's happened to you, too. You sell a stock for no real good reason and then it goes on to be a gigantic winner. Or you are so intimidated by the market and los­ing money that you simply sell with the crowd over and over again and console yourself for the short period of time when that same stock is a little lower, but feign ignorance or even take it off your screen once it's roared back.

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There are any number of risks associated with the stock market; some are tangible and others are emotional. You can get a handle on both with greater knowledge of the market and the stocks in your portfolio. As a self-directed investor, you'll have to modulate the fear of success and the fear of failure and at the same time stop being your own worst enemy.

Understanding the Risk and Reward

A simple equation of knowing what the possible upside is versus the possible downside gives us the risk-reward ratio. This is the key to mitigating losses and achieving a balanced portfolio. Taking risk into account isn't a high enough priority for most investors. Investors always know what the upside is and sometimes they know what the downside is on the charts, but too rarely do they know embedded risks associated with the companies in which they've invested.

Individual investors say they don't need help because they've figured it out. Some have come to this conclusion based on a false confidence in the charts, and others have lowered the bar and now consider not losing money to be success. The main source of this chutzpah came and continues to come from investors making big scores in the market despite taking on incredible risk, incorporat­ing faulty asset allocation, and not doing real homework.

I call it luck but it's really more of a curse, because poor invest­ment habits become embedded and tied in to your psyche with a Gordian knot. Don't get me wrong, luck can be a big part of the game, but you want to get lucky for the right reasons and not the wrong reasons. You want to own the number one percentage gainer in the market because the stock was taken over by some company that concluded it was cheap, just as you did. If you won the stock from a tip, consider the score luck and don't let this be­come your method for playing the market.

Some investors deliberately go for the home run ball every time they come to bat. Each stock in their portfolio has to be a million- to-one play—a company that has the cure for cancer or a technol­ogy that will leapfrog anything Microsoft or IBM has on the market. Sure, these kinds of investments are always lurking about, although they're like the lottery with the multimillion-dollar jack­pot: We know somebody won, but we've never met anyone who has won.

In baseball, sometimes the last thing a manager of a club wants is for a singles hitter (a player who normally hits for accuracy rather than power) to hit a couple of home runs. Why? Well, the home run is infectious; it is the ultimate adrenaline rush, or so I'm told. I remember when former New York Mets player Lenny Dykstra (now a stock guru) was named by fans as the best lead-off hit­ter in the game—no small feat since Ricky Henderson was also playing at that time—he began to hit home runs.

The excitement of watching him hit those homers all the time energized the team and the fans, but after a while it began to hurt his real talent—the ability to get on base. In my mind he never was the same, and he was eventually sent packing from the team.

As an investor, there would be no greater thrill than to wake up one morning and learn that XYZ Biopharmaceuticals has just been granted FDA approval for a cure for lung cancer. That would be like the most famous home runs in the history of baseball, the shot heard around the world (Bobby Thompson), the Kirk Gibson home run in the World Series when he could barely walk to the plate, and the three-home-run performance by Reggie Jackson, all rolled into one.

It's good to dream, but in the stock market it is so much more important to adjust for and plan for risk and worst-case scenarios.

What is the difference between a professional investor and the average individual investor? The professional investor assesses the risk; in many cases it's the first thing he looks at—what is the worst that could happen?

By contrast, individual investors are al­ways counting their chickens first, daydreaming about how high their holdings will go without regard for the possible downside.

The Bottom Line

In order to become rich in the stock market, you have to con­sider and master the following:

· Understanding and planning for risk

· Distribution and allocation of assets

· Timing and exit strategy

· Researching and understanding your portfolio

In order to control your risk and reward properly, you have to be able to control your emotions throughout the entire investing cycle.

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