The Technical Basis Of Risk-Reward Analysis by Victor Sperandeo
Author and money manager Victor Sperandeo offers details on his investment approach in this excerpt from his latest work, Trader Vic II: Principles of Professional Speculation. Here, Sperandeo explains the dos and don'ts of risk-reward analysis.
Risk and reward are two of the most commonly used words on Wall Street, and yet, they are probably
the most ill-defined. They represent concepts that few ever bother to spend time refining because
“everyone knows what they mean.” Risk is generally associated with losing money, and reward is
generally associated with making money. While these associations are accurate, they don't provide nearly
enough information to use as the basis for risk-reward analysis. Just as an atomic physicist would be lost
without a detailed understanding of the nature of atoms, so a market professional will flounder without a
well-defined concept of risk and reward.
Suppose, for example, that you are trying to manage a long portfolio of stocks. As a starting point, the
first question is not which stocks to own, but whether and to what extent to be long. To answer this
question, you must not only have a grasp of the direction of the broader market trend (up or down), but
you must also have some indication of the likelihood that the current trend will continue. Further, if it
does continue, you need some indication, some measure, of how much the market is likely to move in its
current direction before reversing. Restated, you must know the potential risk, and the potential reward,
of being long.