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Greetings, Pro-fundity team members -
07-11-03

At the bottom of the Guidepost, a full listing of this weeks picks are shown, in addition to the Charts via the Pick-link.

As a benefit of membership, you have access to all Guideposts (including Archived GP's) and Picks. If you miss a week or two for whatever reason, you will be able to go into the Historical Guidepost link to catch up with both the weekly guidepost and the 30 picks made for the week.

Greetings, fellow Pro-fundity team members

1. We began a discussion of the basics last week, considering why we should invest in the stock market. This week is the second installment in a beginners forum, to help both novice and experienced traders reassess their view of the challenging market now upon us. Opportunities like this are rare in market history. Enjoy these basic musings during the next several weeks as we prepare ourselves for the opportunity of a lifetime. Consider last week’s offering on “Why Invest?” carefully, as a precursor to this week’s “Risk & Reward.” We even have some questions at the end.

2. Whenever we master some new challenge, it always comes at an expense. That is, it took some work to accomplish. Usually, the greater the challenge, the more work required. Call the new challenge a reward and the required work a sacrifice. Make the sacrifice, reap the reward. In some circles, it’s called the Law of the Harvest. If we don’t sow the seed, we needn’t worry about any harvest. Others call it the Law of Cause and Effect; for every effect, there is a cause. Reward and sacrifice go into every worthwhile effort, including investing in the stock market. In the market we call the investment reward the return. Return is the financial benefit of risking our money in the market. It is expressed as the “rate of return.”

3. Investment sacrifice is called risk. Risk takes many forms, but the essence of investment risk is the chance we take that the value of our investment will decline. You are ready to tackle the one simple fact that underlies investment risk and return: they are both positively and linearly related. This simple graph is worth a thousand words, and illustrates their relationship.

   
   

   
   REWARD

   Fig. 1 Risk/Reward Relationship

4. The risk and return relationship implies that in order to earn higher returns (rewards), we must assume higher risk. If we’re unwilling to accept a higher risk, our returns will be accordingly low. In the long term, all investment securities and portfolios operate this way. Furthermore, the relationship explains why get-rich-quick schemes don’t work: to get rich quick, we must assume extraordinary risks that significantly increase the probability of loss. Rather, the key to successful investing lies not only in a well thought-out plan, consistently applied, but one that accounts for and manages risk.

5. The cornerstone of a good risk management plan lies is an accurate understanding of our own tolerance for risk. This leads to an investment plan that reflects both our personality and tolerance. Risk tolerance is about personal preferences and goals. It has nothing to do with the extent of our wealth or courage. A young, relatively poor couple, just starting out, may be in a better position to assume a higher investment risk than a couple near retirement. Likewise, it takes no more courage to day-trade than to invest strictly in conservative Treasury bonds. Rather, risk tolerance deals with two key attributes: cash flow needs and our attitude about short-term fluctuations (volatility) in the value of our investments.

6. How willing are we to see investment value decrease in the near term, even though we know the chances are it will increase over the long term? How comfortable are we to see our investment drop 40%? 20%? 10%? There will be some value of change that we won’t lose sleep over. As we consider and come to understand where our “comfort” level is, investing will be a lot more fun and help us make fewer panic-judgments. Higher-risk investments are more likely to drop in the short term. Risk can be defined as the variability of returns. If an asset jumps up and down a lot, it is believed more risky than one that stays put or climbs slowly – even though the asset that jumps around a lot may outperform the slower moving assets over time. The basis of risk, so defined, depends upon our own perceptions of the risk.

7. When someone suggests that trading is just too risky, they express their misunderstanding about risk in the market. Trading-risk deals with the probability (likelihood) that a trade will go in our favor. Assessing the level of risk involved in a particular trade is what we learn to do through extensive study and practice. Based on our understanding of the risk, we enter positions, exit positions, and manage our holdings for long-term gain. This is not risky. This is managing risk. Investing without understanding the risks is risky! If we don’t invest the time required to learn to manage the risk, we increase that risk and we’re more likely to lose money in the market. As we learn to better manage the risk in this course, we’ll not only sleep better but have a lot more fun.

8. And speaking of probabilities, is that the same as possibilities? The answer, of course, is Absolutely Not. That difference has built the Mecca’s of Atlantic City and Las Vegas. Something as simple as a roulette wheel, for example, with 36 numbers, half red and half black, seems an even bet, where you might win as often as you lose. If you bet on red, you have the chance to win half the time, right? Even odds! No respectable casino would accept those odds. Rather, the wheel actually has 37 slots where that little white ball can stop (an added zero slot). That means the probability of winning as we bet on the red is not even, but 18/37 (0.486…). That’s the difference between possibilities and probabilities. Is it possible to win, betting on red? Sure, but over the long run, the probabilities lie with the casinos, who are happy to accept that 1/37 chance in their favor. That is how a casino tilts the tables of chance in their favor. Not so in the market, where we’ve shown the odds to be on our side.

9. This is very important to us at this point since it has to do with a lot of money! What seems like small beans, small differences in risk levels, means big differences in the bottom line. You see, the difference in annual returns is magnified over long periods of time. Each small increase in our portfolio is reinvested at a higher rate of return each year, due to the miracle of compounding, and that extra money earns more money. Between 1950 and 1995, we would have earned a total return of over 19,000% in stocks versus about 500% in long-term bonds – almost 20 times as much. It was Albert Einstein who said, “The most powerful principle I ever witnessed was compound interest.”

10. In the end, decisions about where to invest our money are so dependent on the individual that no one-size-fits-all model could ever work for us all. The only way to find the investment model that works is through experience. That means having some experience in different models, at minimum cost. Since none of us can waste thousands of dollars in the school of hard knocks, making mistakes, learning the lessons, adjusting our plans, etc., etc., we move up the learning curve through education, simulations, paper-trials and errors. That is the mission of Pro-fundity. Stay with us.
    07-11-03 Pick Selection:

    Main Picks:
    ADI,BORL,DAKT,DPH,IART,MYGN,SBGI,SEPR,TEX,WAG
    Breakouts:
    CRAY,HMC,ISSI,KMT,LENS,MATR,PPE,SAY,SHRP,TTN
    QuickPicks:
    ATN,BCC,BCO,CCE,CRA,HAIN,LYO,MCH,SHLM,STM

    For detail and followup on Pro-fundity Tradescape,
    find the link on "Advanced Trading Tools" on the home page.

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