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Generating Risk-Adjusted Returns

Part of the Commodities For Dummies Cheat Sheet

Investing is all about managing risk, and here are two ways to approach risk management: (1) According to uber-investor Warren Buffet, Rule #1 of investing: Never lose money. Rule #2 of investing: Never forget rule #1; (2) If you focus on protecting your downside, the upside will take care of itself. Here are a few key risk variables you should be monitoring constantly:

  • Volatility: Volatility is the way that investors measure price variation and fluctuation of a given security over time. The higher the variation, the more volatility. For example, if a security trades at $5 on Monday, $15 on Tuesday, and $7 on Wednesday, it's exhibiting extreme volatility. If you're a novice investor, you should trade these types of securities with extreme care.

  • Standard deviation: Standard deviation is a statistical measure of the amount of volatility inherent in a security. The standard deviation formula is a complex one, but it's extremely powerful and practical. With one number, you can determine just how volatile a security or asset is. The higher the standard deviation, the riskier the asset; conversely a low standard deviation number means the security is more stable from a pricing perspective. A stable Fortune 500 company tends to have a lower standard deviation than a startup tech company. Use this powerful metric to help make better trading decisions.

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