Profitability y the risk They are two key factors when analyzing any investment. The normal thing is that the profitability and the risk are related. Assets with higher risk tend to offer higher returns and vice versa. However, this is not always the case. In this article I am going to explain why when investing in the stock market sometimes the relationship between profitability and risk is reversed and how we followers of the market can take advantage of it. value investing.
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- risk is related to the price we pay for an asset. Therefore, the lower the price we pay for the same asset, the lower its risk.
Furthermore, profitability is also related to the price we pay for an asset. So the lower the price we pay for the same asset, the higher its potential profitability.
The relationship between return and risk with the price paid for an asset
Therefore, if we pay a lower price for an asset, the profitability will be higher, but your risk will be lower. As we can see, the relationship between profitability and risk is not direct, but quite the opposite. In other words, the profitability-risk binomial that should occur in theory is reversed.
Example to understand the importance of the profitability-risk binomial invested in investing in the stock market
The best way to understand this is through an example.
Imagine that you buy a share for € 10 which, according to your calculations, is worth € 20. In this case:
- It has 100% potential.
- The risk is that it is worth less than € 10
Now imagine that the stock price has fallen 50%. If you buy that same share for € 5, as long as your intrinsic value has not changed, the following would happen:
- It has 300% potential.
- The risk is that it is worth less than € 5
As you can see, the same asset can have a lower risk and a much higher profitability potential just because of a change of mood in Mister Market.
Therefore, if we want to take advantage of the opportunities offered by the invested return-risk binomial, we must buy shares of companies with potential when their price falls. I know it is not easy, since the herd effect makes it complicated reverse current. However, staying calm and acting rationally in times of madness is one of the best ways to achieve extraordinary returns in the long term.
I would like to end this article with a phrase from Warren Buffett in which it perfectly explains the inverse relationship between potential profitability and risk in value investing:
Sometimes risk and reward are positively correlated. If you buy a dollar bill for 60 cents, it is more risky than if you buy a dollar bill for 40 cents, but the expected reward is greater in the second case. The higher the reward potential in a value portfolio, the lower the risk