Risk, That 800-Pound Gorilla, Shoves Onto Market's Elevator

The idea of risk often leaves investors' minds but never leaves the market. How do you assess its impact on your stocks?
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Risk has re-entered the tech stock trading room. Whether you define risk as "volatility" or as "loss of capital," there has recently been a lot of it in the market.

By early morning, the

Nasdaq Composite Index

was down 161.1 points, or about 4% on the day. By midafternoon, the Comp was almost back to even before once again sliding deeper into the red. The tech-stuffed index has lost nearly 20% since peaking March 10.

No matter where stocks close today, this is the razor's edge market that can cut you up in a flash. There are already signs of bleeding:

  • Motorola (MOT) last night lowered its earnings estimates for the year and today saw its share price free-fall more than 29 before stopping around 121, well off the all-time high of 184 5/8.
  • The first aggressive growth stock fund to self-destruct has surfaced. CNBC reported yesterday that Foxhound Fund, run by Bulldog Capital Management in Clearwater, Fla., has lost close to 90% of its investors' money, turning about $400 million into $40 million in a few months.

And there are worries of more bloody days ahead.

Merrill Lynch

reported this morning, in a survey conducted by

Gallup

, that U.S. investment managers are "raising cash as technology shares fall from grace." Momentum investors seem to have lost courage. Value investors, who might want to buy companies with P/Es closer to their earnings growth rates, wait for still-lower prices or invest instead in cheaper old-line companies. Meanwhile, more tech stock comes to market and additional IPO lockups expire. There are rumors in the market of momentum investors increasingly shorting their once-beloved tech stocks. Traders talk of the Comp "converging" with the well-dented

Dow

. (By midafternoon, the Dow was still holding onto a 1% gain.)

Where might the tech train be heading? Is the decline simply a valley before the market climbs, fueled by good first-quarter earnings announcements? Or is the decline a harbinger of disaster just around the bend? Or is the train stuck in a trading range? No one knows.

What Must Go Right?

An investor can, however, know one thing about the tech stocks he or she owns: What has to go right for my highfliers to make me the money I want?

The arithmetic is pretty simple. Take

Cisco

(CSCO) - Get Report

, the ultimate tech bellwether of the moment, for example.

Cisco has a market value of about $500 billion, excluding stock options. This year after-tax earnings are expected to be about $3.5 billion. The stock trades at about 140 times earnings. Let's say you the investor want to make a 20% average annual compound rate of return over the next 10 years. What has to happen? Cisco's net income must grow at slightly more than 24% a year, and in year 10, Cisco must sport a P/E ratio of 100. That is just to make the 20% return you want.

If you are 100% confident that Cisco will grow earnings at 24% a year and end up with a P/E of 100, you will make 20% a year on your money. If you are sure Cisco can do that, then keep on with it. If not, then you should re-evaluate holding Cisco. (If Cisco can leap such high hurdles, its market cap in year 10 will be $3.1 trillion. That equals roughly 20% of today's

total

U.S. public equity value.)

You can perform the same simple calculation on any stock or stock index in your portfolio. In this risk-laden market, perhaps you should. At the moment, the Comp is slipping again.