The Investment U E-Letter: Issue # 105
January 17, 2002 Investment Risk: The Lesson We Can Learn from NFL Quarterback Trent Dilfer
By Dr. Steve Sjuggerud, Chairman, Investment U
"The professional concerns himself with doing the right thing rather than making money, knowing that the profit takes care of itself if the other things are attended to." -- Jesse Livermore, 1923 Weeks after leading his team to a victory in the Super Bowl last season, quarterback Trent Dilfer of the Baltimore Ravens was asked, "What talent do you wish you had?" Dilfer's reply: "I wish I could play quarterback." Last season, Trent Dilfer was considered "second-string" -- not good enough to play -- for the first half of the season. His employers claimed he did not have the "natural ability" needed to succeed as a starting quarterback. But mid-way through the season, when he was finally given a chance, he led his team to 11 straight victories and a world's championship. Amazingly, Dilfer then lost his job. (Again, he was considered "second string.") Without him, his former team lost three of their first six games this season . . . and struggled just to make the playoffs. Dilfer was subsequently hired by another team -- again as a "second-string" quarterback -- for this season. He's been asked to be the starting quarterback only four times this year, and he has won all four of those games. In fact, Dilfer's current team has a losing record when Dilfer isn't starting. Trent Dilfer has won his last 15 games as a starting quarterback, playing as the offensive leader of teams with absolutely no offense. So, What Investing Lesson Can You Learn from a Football Player? Reduce Investment Risk! What is it that Trent Dilfer does to win games? And more importantly for our purposes, what is it that we can take from him to become better investors? The answer is simple: Trent Dilfer doesn't make mistakes. That's it. When you're playing at the professional level, where the level of competition is extraordinarily high, all it takes to be a loser is just one big mistake. And Trent Dilfer has compiled his impressive record by mitigating risk…and avoiding that big mistake. When it comes to the stock market, you can often come out on top in the long run by lowering investment risk…and playing it safe. What Separates Winners from Losers in the Game of Investing In the investing world, the difference between professionals and amateurs is also not making big mistakes. But there is one key difference I've noticed between winners and losers when it comes to investing . . . Losers ask: "How much can I potentially make?"
Winners ask: "How much will I have at risk?" Losing investors are wowed by returns. "Qualcomm is up 1,000%? Let me buy some of that!!!" "XYZ Biotech Mutual Fund was up 200% last year? Get me some of that!!!" Winners, as Jesse Livermore's quote above says, already know that the returns will come. So they concentrate on minimizing the investment risks. I've never met a winning investor who talks more about returns than risks. Winning investors think in these terms: for a given level of return, how much will I have at risk? It's the REWARD-TO-RISK ratio. Here's what the ratios look like over the last 50 years or so: Stocks (including dividends): - 15% a year REWARD
- 16% a year RISK (volatility)
- 0.9 REWARD-TO-RISK RATIO
Government Bonds: - 6% a year REWARD
- 10% a year RISK (volatility)
- 0.6 REWARD-TO-RISK RATIO
One thing the reward-to-risk ratio ultimately tells us is that in any given year, we do have a risk of losing money. For example, in any given year, we might make a total return of 6% on government bonds. But in any given year, the likely return ranges 10% on either side of 6% -- from a high of 16% down to a low of -4% return. How To Manage Your Risk as an Investor But the ratios above are based on putting all our eggs in the stock market or all our eggs in the bond market. However, if you take the time to crunch the numbers as I have, you'll find that a portfolio with 50% stocks and 50% bonds, improves the reward-to-risk outlook dramatically: - 50/50 Stock/Bond Mix
- 10% a year REWARD
- 10% a year RISK (volatility)
- 1.0 REWARD-TO-RISK RATIO
By having 50% in stocks and 50% in bonds, your portfolio would be no more volatile than an all bond portfolio. Yet your returns would increase dramatically over that of just bonds, from 6% to 10% (a 66% increase). So by adjusting our mix, we maximize our potential returns, and yet keep our risk at a minimum. No mistakes. No major stock market risk. In this case, with the likelihood of 10% a year in returns, and a likely range of returns between 20% and 0%, you've greatly reduced your chances of having a losing year. As Trent Dilfer has proved in his last 15 times as a starting quarterback, even if you don't have the natural skills of other professionals, you can succeed at the highest levels. Just keep yourself from making the big mistakes. Good investing, Steve Today's Investment U Crib Sheet- The fundamental difference between "winning investors" and "losing investors" is that losers are more concerned with reward, while winners are more aware of risk.
- Understanding the reward-to-risk ratio is the key to effectively managing the level of risk in your own portfolio. As a smart investor, you should adjust your portfolio to maximize your returns while keeping your exposure at an appropriate level for your situation.
- By avoiding the "big mistake" -- either as a quarterback or as an investor -- it is possible to be successful at the highest level… even if you do not have the resources others might have.
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