Investment Basics – Return to Risk Ratio
The market may not be going in the direction you wish all the time. When that happens, we lose money. And we represent the amount of money you may lose with a letter R. We know that this is the largest amount you may lose if the investment turned bad. When we talk about risk, we also consider the potential return in an investment. We estimate the relationship between the two with a ratio in R. In fact, you might already know and actually be using such a method in other aspects of your life, you just need to be conscious of it and apply it to your assets management.
When you are given two choices, how would you come up with your decision? For example, there are two different methods for you to go home, one is to go on the high way, and another one is to go through the street. If you choose the high way, you may be able to get home within 30 minutes if everything is smooth. But there is a possibility that there is a traffic accident and you would need two more hours to get home. Choice number two is to try the streets with fewer cars. There are many traffic lights and whatever the traffic is, you would need 45 minutes to get home.
The way you choose which way to go is the estimate the advantage of arriving home 15 minutes earlier and the hassle of potential traffic jam. This decision making process can be applied to investment management totally. We assess an investment opportunity with the return to risk ratio and see whether it worth noticing.
Top investors describe their market opportunities with return to risk ratios. These professional investors consider their risk factor, the R factor. If in an investment event your potential return is 3 times of the possible loss, we say it is a 3R opportunity. We use this simple notation to denote our investment opportunities, no matter it is stocks, mutual funds, properties or other investment tools. A 2R profit means the same in stock or property market. It means the potential return is 2 times the risk you bear. Let us see some examples.
The first example is the situation where you have already decided to buy a house with a compromised price and sell it quickly thereafter. This is a quick cash transaction. You have decided to use USD5000 to buy a USD80 000 house. The amount USD5000 is the risk factor R which is the largest amount you can bear to lose. You wish to sell the house with a USD100 000 price. That is, a USD20 000 profit. This will be a 4R opportunity, because your planned profit is 4 times of the risk you bear.
Let’s say it turned out the market didn’t go up as much as you thought and you sold the house with $90,000. You made a profit of $10,000. So, we say the investment becomes a 2R one because the profits is 2 times the risk factor.
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