Investing: When to bet the farm

You want a big return? How big a risk do you want to take to get it? Gauging the risks associated with really promising investments, and handling those risks appropriately, can change your life.

"It's never safe to take a risk, by definition," says Carl Luft, an associate professor of finance at DePaul University in Chicago.

Yet successful investors take major risks all the time. They succeed because they do their research, can afford to lose the money they invest in high-risk schemes and are able to make up any losses they incur with other investments, which frequently involve complementary or counterbalancing risks.

Whether considering an investment in a stock, a privately held startup or a hedge fund -- all high-risk propositions -- investors should start by digging through the details of the business case to figure out how the return on investment is likely to be generated. How big a payoff might the investment produce? And how likely is success?

Successful investors look hard at the downside as well. What would the price of failure be? And how likely is that?

Just jump in and take a risk

And what about all the outcomes in between?

Luft emphasizes that successful investors tend to have a broad view, taking the downside into account with the upside. They plan on an outcome somewhere in the middle of the range of possibilities. That is their "expected return."

"An expected return is an average," Luft says. "It's the probability of all of the outcomes."

Risk assessment gets pretty sophisticated at risk-oriented hedge funds. These funds combine and counterbalance risks to put together exotic investment strategies that increase an investor's upside while controlling the downside -- all for a price. But the basics are just common sense.

Russell Lundeberg, the chief investment officer for Barrett Capital Management in Richmond, Va., spends his days researching investments both risky and safe for the wealthy families in the firm's client base. He researches basic business practices as well as the big-picture business opportunity.

"The No. 1 most overlooked aspect of hedge fund due diligence is on the operational side," he says. "The things that can be potential risks and pitfalls are not always easy to spot."

Among the not-so-obvious business risks, Lundberg mentions high employee turnover, sloppy accounting and computers that aren't backed up. A mistake in the office can wipe out an investment's potential return even in the most promising environment, Lundeberg says.

Our own personalities add complexity to high-risk situations.

Bill Gurtin of Gurtin Fixed Income Management in San Diego points out the risks associated with overly emotional reactions.

"What you don't want to happen is for people to get emotional with the market," he says.

The more emotional we get, the more likely it is we will make a mistake, Gurtin explains.

A company's business prospects can be measured and evaluated statistically, but there is no easy measure for mood swings. Before making any moves, people contemplating high-risk investments should come to grips with their emotional makeup and know how they are likely to react.

Graphic: Three ways to analyze a company

Where risk is high, the investor needs to analyze his or her life situation.

Is financial risk really risky?

"There are times in your life when it's appropriate to take different levels of risk," Gurtin says.

Age is a big factor. Age changes us in a lot of ways. We gain emotional maturity. At the same time, the nature of our financial obligations changes, and the time horizon for risk gets tighter.

"Let's say you're young, in your mid-20s," Luft says. "If you take a big risk and something goes wrong, you have time to recover." On the other hand, the middle-aged homeowner probably needs a bigger safety net, especially if there are kids who need braces or there are college costs to consider.

Even a high-risk investment can be a very positive part of a portfolio when it's appropriate to a person's situation and is well-managed.

"In investing and in life, you have to look at everything on a risk-and-reward basis," says Manny Weintraub, the president of Integre Advisors, a New York firm that manages equities for long-term growth. "Volatility is not the end of the world."

Risk lesson from the OTB

Weintraub is a good example. He left the investment firm of Neuberger Berman in 2003 to start his own firm. He knew most new businesses fail, but he had a lot of confidence in his own investment skills. If the business went under, he reasoned, he could always get a job with another firm.

"Careers are actually the easiest place to take risks, as long as you don't burn your bridges," Weintraub says.

Luft suggests younger investors, particularly, should be ready to gamble with their careers. But in the same breath he cautions as professional investors often do: Risk only as much as you can afford to lose, he says.

Published Aug. 28, 2008