You’ll often hear the term risk/reward ratio. Part of this is understanding how a stock generally moves compared to the market (or other stock, or whatever you’re comparing it too) There a a few tools or concepts that are helpful in analyzing risk.
Stock Alpha
The alpha measures the return (or loss) compared to the expected return. If your pricing model predicts a stocks return to be 7% and it has returned 9% then the alpha would be 2%.
Stock Beta
Stock beta or the beta coefficient is calculated using regression analysis. Essentially it’s a stock’s volatility compared to the market. Beta of 1 means they move the same, 0.5 means it’ll likely move 1/2 as much as the general market. Less risk but less reward. The stock beta of Lowes is 0.83. So Lowes is less volatile then the general market.
Sharpe Ratio
The sharpe ratio is the (expected return – risk free return)/standard deviation of returns. This ratio allows you to compare two investment choices and determine which ones has the best possibility of return without adding too much risk to your investment.
Remember, even with your best ideas the volatility can either physically or mentally wipe you out, you have to understand just what the potential swings are and what you can handle before you enter a trade.
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