How I Find Lower Risk/Higher Reward Stocks

There are four key attributes I look for in a stock: an attractive valuation, good financials, a strong business model and the ability to add diversification to my portfolio.

These traits are based on some of the great investment literature that has been written over the past 100 years. For example, Benjamin Graham and David Dodd emphasized the importance of book value in “Security Analysis” (1934). Philip Fisher stressed the importance of a good business model in “Common Stocks and Uncommon Profits” (1958). And Harry Markowitz revolutionized portfolio management by showing that diversification can increase returns and lower risk at the same time.

When you combine attractive valuations, strong financials, a good business model and the ability to add diversification, the result is a good risk-reward ratio for a stock.

What is the risk-reward ratio? It is a measure of the probability a stock will decrease in price (“risk”) versus the probability that a stock will increase in price (“reward”). The lower the amount of risk and the greater the potential for reward, the higher the probability that the stock will turn into a profitable investment.

To measure a stock’s risk-reward ratio, I developed a scorecard for my new book, “Better Good Than Lucky” (W&A Publishing and Traders Press Inc., 2010), based on these four key attributes. Since investing is messy as opposed to an exact science, I assigned a range of scores for each criterion instead of requiring that a stock meet specific characteristics. It is extremely difficult to find the perfect stock, but there are many stocks that are capable of helping you build wealth. Therefore, the goal is to find stocks whose potential rewards outweigh their potential risks.

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