Continuing on our recent theme of structuring and building stock and alternative investment portfolios, I wanted to share a few thoughts on how risk ratios play into asset allocation.
When assessing any opportunity, it’s important to look at the best and worst case scenario, at least taken to a reasonable degree, then compare the potential gains versus the potential losses to get a risk ratio. Defining the downside is relatively easy stocks by setting stop losses set at a reasonable amount below the investment value.
In alternative investments, it’s not quite as easy as setting a stop loss sell price. To start, there’s the problem of valuing alternative assets. Values can only be considered estimates until a sale occurs, as prices often can fluctuate significantly in private asset sales. That leads to the second problem of a limited market of buyers for alternative assets. Alternative assets are decidedly less liquid than stocks, so when considering the worst case scenario, you need to consider the actual value if you needed to liquidate for cash within a reasonable amount of time. That time changes based on cashflow requirements, type of asset, and other variables that can be assessed on a case by case basis.
The upside is a relative guess for both stocks and alternative investments, though assets like real estate are typically much easier to estimate than a single stock or a single angel investment. In all cases, it’s important to come up with a reasonable estimate of the target value, should everything go right.
From there, it’s easy to get a risk ratio by dividing the potential gain by the potential loss. A high risk ratio means there’s more upside and implies the likelihood is decreased. While true, it’s important to account for how much capital is at stake and know how often you need to be right in order to win.
Working through these numbers before making an investment can help visualize how the investment plays into your portfolio, in terms of capital at stake, the worst/best case scenarios.
For our own investments, we set our numbers at the initial time of investment, then reassess occasionally by updating the target price, market/estimated value, low value, etc in a spreadsheet, based on any new information/developments. By using the spreadsheet, we get a chance to quickly reassess each investment and see how our assumptions affect our portfolio as a whole, potentially triggering other changes, including changes to our asset allocation.
Our own spreadsheet is based on Chris Perruna’s spreadsheets, which he included in a post on Position Sizing & Expectancy. Give that a read for more info.
We’re working on updating our portfolio tracking spreadsheet to work with a combination of stocks, crypto, and alternative investments. We’ll share a template when complete.