Risk - Is it Constant?

Recently, during a lunch with a friend, we got talking about the stock markets and the perceived risks.

Some of the questions my friend posed during the conversation and my responses is what I have tried to re-capture here.

How do I take calculated risks while buying stocks? I feel that we can't 'calculate' risks especially in the stock markets. We can employ strategies to mitigate the risk but not necessarily 'accurately' calculate it. Our lifetime is finite, our ability to process knowledge is finite, our money which we can put into the market is finite, our efforts to put all this together is finite. So how can we manage or for that matter calculate the multiple variables and the infinite combinations thereof which contribute to risk. Focus on risk mitigation.

Why is risk in a trade constant at the same time relatively different?

In any trade the risk for gain and loss for any party is the same. After all, a trade is entered when a buyer and seller agree on a transaction price. Unfortunately, the counter trade is not always with the same party with whom you initiated the trade.

Let's assume that for every trade we enter we are either willing to make or lose in the ratio of 2 : 1.

Now if I enter trade (buy a stock) with the same ratio in mind and I am willing to make Rs 20 and lose Rs. 10.

On the other had you entered the same trade to make Rs. 10 and lose Rs. 5.

In both scenarios, the ratio of win-loss risk is the same but the risk is relatively different. The above ignore the fact of how the risk is valued by the individual (you or me) differently.

If you plotted it on a risk appetite (y-axis) vis-a-vis age (x-axis) graph; the plot of this graph will be more like a parabola (almost).

By drawing a line for any value for risk (parallel to x axis), it will meet at the parabola at 2 different points of the graph. Does it mean that the individual's risk appetite at two points in his life is the same? Actually, it never is. Here again, risk is the same but it actually is different.

I may have oversimplified my case above and there will be enough number of people who will argue against it but then complicating any situation need not necessarily gave you a more accurate answer.

In our lives (and so in the stock markets), we are always living (and trading) by guesstimates and approximations of huge number of variables. We try to improve our approximations by making some of the variables as constants. This is nothing but an act of risk mitigation than risk calculation.