The Risk-Reward Challenge

There is no need to explain why analyzing risk and reward is the key to investing.  There are a number of potential risks in the market, but let us try to simplify a bit for this challenge.  We shall focus on the economy, recession chances, and the potential for a soft landing (or as we prefer, the Glide Path).

To do this properly, one needs to answer three questions:

  1. What are the recession odds?
  2. What would happen to stocks if a recession occurs?
  3. What would happen to stocks if the glide path is achieved?

When you have a blended expectation, you can compare it to the interest rate of your choice.  The key element is to discover where one has the biggest exposure.

The answer might be different for individual investors (wanting to avoid big moves in either direction) and traders or fund managers (wanting to beat benchmarks).

At "A Dash" we suspect that most market participants focus on the probability of moves rather than the potential size of moves.

Have you done this analysis for your own portfolio?  What is your conclusion?

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  • Jason October 18, 2006  

    Well, for what its worth, here are my 2 cents.
    1) Not very likely (I would give a number, but that wouldn’t be very useful without some error estimates).
    2) It would be very, very bad for stocks.
    3) The upside would be pretty limited, IMO.
    So that being said, while I think the soft-landing people are right, I’m not entirely convinced that one should be in stocks.
    Also, I’m no good at making macro predictions, and am not really about to start placing bets on that. Speculating on it is still fun though. As my father always used to say, it is better to be lucky then smart, but it is even better to know which you are. I’ll just stick to bottom-up research.

  • oldprof October 18, 2006  

    Jason — Thanks so much for weighing in with your comment. I think that many share your views. I plan to describe a method for meeting the challenge. For now, I hope that other readers will also comment.