Understanding Risk vs. Reward in Alternative Investments
There are a number of key traits that any investor must have, but nothing is more important than learning to identify risk. Without this crucial skill, a dream of riches can turn into a nightmare of regret overnight. Though this article does not relate specifically to one market (private placement, managed forex, managed futures, etc.), its importance can NOT be understated.
Before we get to the good stuff, let’s identify the 3 critical steps that must be followed when considering any alternative investment. Generally, these processes should be used by all investors, and MUST be completed to succeed in the alternative investment world.
Steps to Evaluate Alternative Investments
1. You must define the risks associated with the investment you are pursuing, and make your choice based upon your tolerance to it.
2. You must properly estimate the reward, focusing on realism rather than hopeful expectations.
3. You must weigh the risk of the investment and against the reward, choosing the decision that aligns with your investment goals.
Though this may seem simple, it is really not that easy. Without proper analysis of both risk and reward, your mind wanders, and problems can typically occur shortly thereafter. Even though weighing risk vs. reward is the key to success, to complete this process correctly, you must first understand how to evaluate them separately. In the section below, we will teach you how to do just that, providing tips for private placement, managed futures, forex and more.
In the alternative investment world, RISK is thought of differently than in other facets of life. In all actuality, RISK should be thought of as the CAPITAL INVESTED + OPPORTUNITY COSTS. To help you understand some of the typical risks in alternative investments, we have provided some critical tips below.
Managed Futures: Risk is typically assessed by looking at the audited history of the managed futures trader, focusing on the max “draw down” months. Though this usually worst case scenario you will encounter, it is quite possible the losses could be higher in future months. Once you view the history of the managed futures trader, have a discussion with them about the “stop loss” strategy and procedure to prevent losses for their investors. Usually, good traders will “flag” the accounts, and trade conservatively until the balance is built back up. Generally, risk is limited to 15-20% of the account value, but many traders can lose even more with a bad position.
Managed Forex: Risk in managed forex investments is usually defined by the leverage and “stop loss” procedure of the trader. Though you should always look at the history of a forex trader, in many cases, investors are choosing private FX investments over licensed ones. Since private traders are not audited by a government agency, their returns should be ALWAYS considered hypothetical. In licensed forex investments, you may have lower returns, but you usually will have lower losses as well. In private managed forex, you must be prepared to risk your entire account value, no matter what promises are made.
Private Placement: Defining your risk is critical to your success in private placement programs. Despite what many brokers say, your assets must be collateralized (i.e. put at risk) to stimulate a line of credit for the trader. If you choose to work with programs that “ping” your account, or let your funds remain in your account unencumbered, you are usually setting yourself up for disappointment. In this market, more than any other, you can lose a large amount of money in OPPORTUNITY COSTS. In many cases, people spend years looking for the right program. If they were smart, they could have doubled their money several times over the course of that search.
As we’ve said before, identifying risk properly is the key to protecting yourself. Even if you don’t have the guts to pull the trigger, it’s crucial to learn and understand your risk. Once you properly determine that risk, you’ve accomplished the hard part. Now you are on to the next important step, projecting your reward.
In the alternative investment world, REWARD should be thought of as the profit you earn and withdraw over the course of your investment. Until you have the money in your hand, any talk of “rewards” should be considered premature. Unfortunately, many people focus on future hypothetical earnings, losing touch of reality and risk in the process. Once an investor drifts away from acknowledging the risk associated with an investment, all hell can break loose. As we have stated prior, prospective “rewards” should NEVER be the sole reason for making an investment decision. If you’re smart, you’ll address all other aspects first, focusing on yields once you feel comfortable.
Now that you know how to evaluate risk and reward separately, you have arrived at the final step, weighing the two against each other. The good thing is, this is really the easy part! If you’ve defined your risk and reward properly, it should be as simple as comparing pros and cons. Once you complete this final stage of the process, it will become far easier to substantiate future investments. Eventually, by adhering to the process we’ve discussed, your experience and diligence may just carry you to riches.
To summarize, whether you want to list “pros and cons” or ponder the risks and rewards, risk assessment techniques are fundamental to your success. Once you identify the specifics of a transaction, it’s always good to go through the key points we’ve listed above. Due to the cutthroat world we live in, it’s always best to evaluate risk before reward. After you do, you can weigh them based upon your goals and risk tolerance. This will keep your eyes open, facing the facts of the transaction, rather than daydreaming into your fantasy of riches…
InsideTrade LLC Staff
Phone: (949) 444-2111