What is the risk of investing?

In short, risk is, in terms of an investor, the chance that an investment will result in a loss. To be more precise: Risk is the probability that the downward potential is partially used before investors can anticipate. The latter is important because if an investor knows in advance that a stock will fall, then the investor will not buy the share. The investor would try to make a profit of the downward potential of a share by, for example, buying put options or sell call options.

As mentioned, the risk is determined by the downward potential of an investment. On the other side of risk is the probability that a share rises by using the upward potential.

How to use the expected risk?

Because you can never know for sure whether a stock will rise or fall, simply because the market determines the price of a share, an investor should determine the downward and upward potential of stocks. From these expectations the investor can determine whether the investment will end in a positive or negative way. If the risk of a downward price movement is less than the probability of an upward price movement, then this will result in a the purchasing of the shares (if there are no better opportunities). Another investment product, with the share as underlying asset, can also be invested in.

It is also possible that expectations of the investor result in a net risk, the risk of a fall is considered greater than the probability of an increase. If this is the case, then the investor will ignore the share, or try on the previously described method to benefit from the share price movements.

How do you determine the net exposure?

For determining the net risk, first the downward potential must be specified. This downward potential is theoretically always the difference between the current share price and zero. To add some more company specific variation to it, an investor should take a look at the annual report of the company. In the annual report, an investor can see what remains for the shareholders in the event of bankruptcy. This is the only number that, according to a fixed method, can be determined.

For each investor the probability that a company goes bankrupt is different. After the investor has estimated the probability that the risk will occur, a value may be assigned to the risk. This can be done by multiplying the downward risk potential.

The expectation of the upside potential will also be different for each investor. There are several ways to determine the upward potential, such as valuating the future profits of the company, estimate the future dividends or evaluate the potential of an acquisition of the company. All these different options have different probabilities of occurrence. It is up to the investor to assess the probability that a particular scenario will become reality. The potential for a profitable investment can then be determined by multiplying the perceived upward potential with the probability that the scenario becomes reality.

The net exposure or net probability can be determined by deducting the negative number (the risk from the positive number (probable profit potential). If the result is positive, the investor can act on this result. When the result is negative, this investor can also act on this, only in a different way.

So...

Risk and opportunity are two things an investor should always bear in mind. But risks and opportunities should not be confused with the upward or downward potential (the margin for an upward or downward price movement of an investment). The potential of a share may be used by an investor to assess the risk of loss or probability of profit.