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Lesson 11. How to Pick Stocks > Determining Your Acceptable Level of Risk - Pg. 62

How to Pick Stocks 62 Remember the blue chip stocks from Lesson 5? Those companies are solid, with no real fears of going out of business; whereas on the other end of the spectrum are those companies that have started out with a couple of quarters and a shoestring. These companies can't justify an investment in themselves, because they own little of real value (what's a shoestring really worth?). However, any one of these companies might turn out to be the next Microsoft, Iomega, or Coca-Cola; or they might simply go belly up, in which case you would lose your total investment. This concept differs from the other definition of speculative investing in that you could still be buying the stock for the long term, expecting that the world wasn't yet clamoring for whatever product or service the company provided, only because the product or service (or the company for that matter) was still new and/or undiscovered. While this scenario is the dream of all investors (who wouldn't have liked to have bought Microsoft when it first went public?), it's rare enough in its most basic form that those who buy these types of stocks (short-term-gain earners or extensive-capital-gain earners) are often referred to as "specu- lators" rather than investors. Hint: These types of investments are "long shots," not the well-re- searched, well-thought-out types of investments you and I are aiming for. Determining Your Acceptable Level of Risk Determining your investment strategy will largely depend on your stomach for risk. Risk is the prob- ability that you will lose the original amount you put into the investment. Notice the qualifier "original amount." As a rule, if you lose all your profits and wind up back with the original amount you invested, for investing purposes you've broken even. Although that scenario would be a pretty pathetic in- vestment by anyone's standards, it is still better than losing everything, including the original amount invested. It's important to determine the level of risk you are willing to accept. Decide what the risks are to your investment, evaluate these risks, and decide whether or not you are prepared to accept the risks. Think of the concept of risk and return as a footrace in which stocks are the runners and the course has lots of potholes. All the stocks are trying to make their way to the finish line (payoff). The younger, lighter, less-established stocks certainly move faster toward the finish line, but they stand substan- tially more chance of getting tripped up by a pothole. The older, heavier, and more established stocks don't move as quickly, but when those potholes come up it's going to take a pretty deep one to make the stock slow down, and an even deeper one to make the stock stop altogether. So why bother to take chances at all? Because risk and return are directly correlated to one another. The less risk you take, the less chance you have to make a profit, or capital gain, as depicted in the following illustration: Tip Figure 11.1. The relationship between risk and return.